Delta-Hedging Options to Trade a Volatility Forecast
Summary
The document explains how to express a view that future realized volatility will differ from the volatility implied by options. If implied volatility seems too high, the example strategy is to sell options and hedge their delta with shares; if it seems too low, buy options and delta hedge. The worked example uses a one-year at-the-money call on SPY to illustrate the option premium, delta hedge, share exposure, and capital and margin considerations.
A delta hedge must be rebalanced as the underlying moves, and trading costs reduce returns. The position also retains vega exposure: a rise in implied volatility hurts a short option position, while a decline helps it. The potential profit depends on implied and realized volatility diverging in the forecast direction, after hedging costs. The discussion is an illustrative answer rather than a complete trading plan; it notes that dealers may hedge more efficiently and does not establish that any volatility forecast will be accurate.
Key ideas
- A volatility view can be expressed by buying or selling options when implied volatility differs from the forecast of realized volatility.
- Delta hedging with shares reduces exposure to changes in the underlying's direction.
- Rebalancing a delta hedge incurs costs that reduce the strategy's potential profits.
- An option position retains vega exposure, so changes in implied volatility can affect its value.
- Margin requirements and competition from more efficient dealers are practical constraints.
Tags
Full text
# Hedging predicted volatility # Hedging predicted volatility > Q. If you predict the volatility of the stock is 10% a year from now and current price is X dollar, how do you hedge the risk? Im not sure why I am finding this so hard. How do we use options (probably) to sell 10% a year volatility? ## Answer by AlRacoon (score 2, accepted) https://quant.stackexchange.com/a/58015 If you are predicting lower one year volatility than the options are pricing in, sell one year options on the underlying that you think will be lower and hedge the delta. If you are predicting higher one year volatility than the options are pricing in, buy one year options on the underlying that you think will be higher and hedge the delta. Your hedging costs will go up every time you need to adjust the hedge and will eat into your profits. You could also hedge the other risks (ie: interest rates--rho) but that too will decrease the profitability of your strategy. So as an example, SPY 1 Yr at-the-money (spot=strike=340) calls are trading at 28.72, which implies a volatility of 22.65%. The delta of these options are 0.53. If you believed that 22.65% is too high (realized volatility would be lower than this over the next year), you would sell these calls, and buy 0.53 shares of stock for every option you sold. Since exchange traded options are for 100 shares, you would sell 1 contract for 2872, and buy 53 shares of SPY. On an unleveraged basis, you would need 340*53 = 18,020 to purchase the shares, and you will receive $2872 for the call you sold. Your margin requirements with your broker will determine how much capital you will need to post to maintain your position (you may be required to post additional margin if the position works against you). You will need to rebalance this hedge periodically to maintain delta neutrality or to eliminate your exposure to the direction of the stock movement. How frequently you hedge will depend on your risk appetite and your costs of trading. If you are correct, you will extract profits from the implied volatility being greater than realized volatility over the year (less the hedging costs). You will be exposed to vega in the price of the option (currently 133.62) meaning the contract will go up by 133.62 for a 1% increase in the implied volatility. As you are short the option, this will work against you if implied volatility increases, and work for you if implied volatility decreases. Bear in mind, you will be competing with the dealers who can hedge much more efficiently.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.