Hedging (aka, neutralizing) option delta and gamma (FRM T4-19)

[my xls is here trtl.bz/2HjdxQq] To hedge options Greeks, we want to rely on the formula: +/- Quantity * %Greek = Position Greek, where a short position is represented by negative quantity. In this example, the market maker writes 10,000 ATM call options, each with percentage (per option) delta of 0.550 and gamma of 0.0440. This creates -10,000 * 0.550 = -5,500 position delta and -10,000 * 0.04400 = -440 position gamma. To neutralize (fully hedge) the gamma, the market maker buys OTM 12,055 call options, each with percentage delta of 0.270 and percentage gamma of 0.03650, which has position delta of 12,055 * 0.270 = +3,250 and position gamma of 12,055 * 0.03650 = +440. Due to -440 + 440, position gamma is now neutralized. However, position delta is -5,500 + 3,255 = -2,245 such that the market maker buys 2,245 shares (shares have 1.0 percentage delta and zero percentage gamma) and with that trade, both delta and gamma are neutralized.
Discuss this video here in our FRM forum: trtl.bz/2Mi5BmX

[@yongruimi8007]

Just wanna appreciate how crystal clear you explained this complex hedging problem. Your video is by far the most friendly and clear tutorial among all resources i've browsed (including Coursera, Udemy and KZbin)

[@bionicturtle]

Thank you, we appreciate your kind words!

[@Saleemlala1811]

Amazing video and great explanation! Have been going through your channel, it definitely deserves more attention! Superb stuff 👌

[@j.s.9981]

@bionic turtle: Finally, a video that takes the complexity of delta, gamma, vega hedging out so the common man like myself can actually understand it. Thank you for a well explained presentation that give me confidence that i can successfully isolate the negative effects of these pesky Greeks to allow me to unlock profits on my trades at a faster pace. (I normally sell defined risk strategies for premium when IV is high). The undefined strategies are used when IV is low and premium is low.

[@ricomajestic]

How do you make money if you are delta, gamma and vega neutral if you are just a retail income trader?

[@worldnomaderic]

@@ricomajestic You can make money by taking advantage of theta decay. The value of an option will decay over time and assuming delta and gammas neutrality, you can make money regardless of the direction of the market. I recommend checking out another channel called Real P&L (I'm a customer with no paid affiliation). He has a trade structure that is delta/gamma neutral and makes money. it's called the premier Level 5 trade. Good luck.

[@ricomajestic]

@@worldnomaderic Yea but he's not vega neutral according to my understanding of the structure. He's delta and gamma neutral but the structure has a large negative vega. Are you subscribed to the Premier Level 5 service?

[@worldnomaderic]

@@ricomajestic yes I am a subscriber. With this structure, you make money when the underlying goes down. Why would we want to be Vega neutral? You are correct though, we are not Vega neutral, but that isn't the goal.

[@ricomajestic]

@@worldnomaderic I've been thinking of signing up to the Premier Level 5 service for awhile now and might do so soon. Do you happen to know what the maximum risk is on the structures that he trades? I asked him once but he told me the maximum loss that he's experienced trading that structure (around $2000) whereas I want to know what the worst possible loss can be. I know he uses SPAN margin to trade that structure but the reg T margin required is probably more useful since that gives you an idea of the max possible risk.

[@olvinfuentes7514]

I remember watching this video 2 years ago when I first begun options trading and I didnt understand anything! Watched today and it made alot of sense! Definitely will help me in the future in unusual options trading and knowing the dealers gamma position.

[@scarfo441]

this is the most important video i have seen in 4 years..i cant stree how important this video..

[@vijay00001]

Thank you very much Sir.. Your videos are very informative.. I am learning from your videos .

[@angstrom102]

Excellent teacher! Thank you!!!

[@TheFeintOfHearts]

This was very well explained, thank you!

[@dees6844]

can u pls send me ur mail I have a very important question related to an assignment I'm solving due Sunday I could really use your help

[@AnjaliSharma-pz6uw]

Thank you. That was crystal clear

[@paisithsengsouriya4678]

Thank you, very good information.

[@ricomajestic]

Interesting video and great information. So how can a retail income trader use this information since if you are delta, gamma, and vega neutral at all times you would not profit from theta decay? Can you use this if your position goes against you - to dynamically hedge a position to prevent further losses?

[@laxmikantchitare3440]

Very helpful, thanks!

[@bionicturtle]

Thank you for watching!

[@nicucristian6030]

One question, can this procces be automated, like with a program, to dynamicly hedge all of the greaks, or just delta and profit on the premium u get for selling the option?

[@prasadkamath1205]

really helpful!

[@markmorrissey672]

Hi - I really liked this video and would like to learn more about greek neutral strategies. I assume that given neutral the profits are made with a positive theta portfolio. I was wondering how I made obtain the spreadsheet you have? I noticed it taken down. Thanks!

[@micheledelmoro6394]

Very clear!

[@georgee1405]

In this example would the exp date be the same on all contracts or does it not matter.

[@zackthecat5142]

Awesome channel and awesome video! Will a brokerage house let you short more calls than the long underlying shares? Don't all short calls have to be covered because of the theoretical infinite loss?

[@TheFeintOfHearts]

For retail traders, this is generally true. For an institutional trader, the broker is the investment bank so they will let an institutional trader take way more risk. This guy started out the video by saying this is from a market maker's perspective, not a retail trader's.

[@WiCapitalco]

You wouldn't be able to hedge a neutral position over time without hft algorithms

[@dr.michaelj.stefano8113]

THERE ARE MORE LONG CALLS THAN SHORT CALLS as seen from this example, SO NONE OF THEM ARE NAKED. THE LONG CALLS COVER THE SHORT CALLS AS LONG AS THEY AREE IN THE SAME TERM OR A LONGER TERM. YOU NEED SPREAD APPROVAL OPTION TRADING LEVELS TO DO THIS THOUGH. CHECK WHAT THE APPLICATION PROCESS IS FOR YOUR BROKER

[@BH-pl7vg]

How does a gamma squeeze take place if options are used to neutralize?

[@filipeefei]

Excellent video, thanks a lot.. I have one doubt.. Is it possible to neutralize Gamma of a portfolio, using only SPY? In other words, how to calculate total Gamma of a portfolio, like we do with Delta-Beta (weighted Delta or Delta Dollars). Or in case of Gamma is only possible to neutralize individualy per underline position? What about Vega?

[@LosizakII]

Awesome. Thanks!

[@bionicturtle]

You are welcome!

[@VirmanaMarketing]

Fantastic job. So the job of the dealer here is to hedge its position and keep the premium collected. Let’s say you have an open position, how often do you assess the position and adjust the hedge? Is it when you are living on the edge of you risk graph? Thank you in advance. In addition, say you are selling SPX options or /ES options… how would you calculate the number of shares of SPY to purchase given the leverage of the instruments.

[@rajubln3]

For option 2 If gamma=0.40and vega=0.50 how we will solve the equation?

[@rakid123]

question please. how to convert position greek (delta, gamma) into actual hedging dollar representation ?

[@j.s.9981]

Good explanation however I would have liked to see the investment capital required to place these trades to hedge. Hedging is known to be expensive especially during periods of high VIX and these trades may not work for small accounts or even large accounts for that matter. One additional set of columns that reflect the costs of shorting the calls, going ling the calls and buying the shares, which of course can be a large debit depending upon the underlying ticker.

[@okopnik]

Wonderful explanation! I'm on the other side of the fence from you - retail trader, only generally familiar with the institutional perspective - and this just pulled all my fuzzy ideas about how MMs do hedging into sharp, clear focus (I could never figure out how you'd hedge, say, vega without messing up gamma.) Thank you so much - I've just subscribed, and am looking forward to more of your content! My only question is, how do you choose the strikes for your OTM calls/puts? I noticed that they were ~1/2 of the inventory percentage delta, but I have no idea whether that's intentional or happenstance.

[@marcellosansonetti7951]

Thanks!!!

[@bionicturtle]

You're welcome! Thank you for watching! :)

[@BH-pl7vg]

You made this very concise, good job! This would not exactly be very beneficial for a retail trader unless attempting to make very small profits with low risk, correct? (If traded correctly)

[@TheFeintOfHearts]

That's correct. This is a hedging technique used by market makers, who have a very different mandate than retail traders.

[@dr.michaelj.stefano8113]

PRE EARNINGS IV CAN BE RICH. IF YOU COULD CAPTURE THE ANTICIPATED CRUSH BY SELLING IT WITHOUT DELTA EXPOSURE IT COUL BE LUCRATIVE

[@bmwman5]

Enjoy your videos, thank you. 😺🇺🇸👍. However, this looks good on paper, but does it work in the real world?

[@bionicturtle]

Thanks. Well, I can tell you that market makers actually do do it (in our forum i routinely get questions about actual use cases)

[@bmwman5]

Bionic Turtle ok I’ll give it a try in my acct and see what happens. It’s tempting to try out.😺

[@bionicturtle]

@@bmwman5 oh geez did we create a monster ;) FWIW, I don't trade options so i'm not advocating (the use case that I am familiar with is an INSTITUTIONAL perspective, not a personal perspective. Very different). I might try options one day, but time decay is contrary to my need to be patient. Here is my portfolio (although I added Yext earlier in the week, which worked out so far): seekingalpha.com/instablog/3329-david-harper-cfa/5274718-tech-turtle-portfolio-status-update

[@dr.michaelj.stefano8113]

this is what the market makers actually do to offer you an option market

[@HongBXia]

@@bionicturtle Thanks for the clear explanations! I am shocked to learn you do not trade options, because you explained the delta-gamma hedging the best. In fact, I use delta-gamma hedging when a leg of my short options is tested.

[@majorboi8863]

thanks

[@albert87jjy]

Is it common for market makers to hedge their short options with long calls/puts? I thought everything was hedged dynamically using underlying shares (long/short). If this is true, does that means share volume from hedging flows is a lot lower than most people think?

[@MacGuffin1234]

Yes. You cannot hedge gamma with shares because the gamma of shares is always 0. I don’t know about the shares volume being different than what’s reported though.

[@dewanehill1232]

@@MacGuffin1234, you may know the answer to this question. Looking at it from the MM perspective, how is the MM able to hedge with options? Wouldn't the MM be on both sides? Or is this more theoretical and meant to say that the entire book is looked at as one trade. All the deltas, gammas and vegas from all the contracts are matched up dynamically and a number of shares needed to balance is spit out. Is that right? If so, how often would the MM balance?

[@jnnero123]

do i need to keep adjusting delta on weekly options? what about a big move in interest rates? tho?

[@Tfkproductions00]

yes, I believe you have to be on top of the gamma and delta movements going forward and that it isn't just a one and done. can someone confirm?

[@jnnero123]

yes you need to adjust daily

[@TrendTrackers111]

How to manage these during the open trade?

[@bodynutrition201]

At around the 1:45 mark you say that Gamma is exposure to big moves and delta is exposure to small moves. This doesn't make sense to me because gamma shoots up around the strike and tails down the further you go from the strike, which to me means that gamma is exposure to small moves the way I picture it in my mind. Can you explain what you mean please?

[@j.s.9981]

We need to keep in mind that Gamma is actually the rate of acceleration or deceleration of the underlying stock price. The larger the moves (i.e. volatility), the larger the impact gamma has on the overall pricing of your options at any time before expiration. This is especially true for options that are ATM since their delta is at 50%. In that same regard, gamma is the second derivative of an option's price with respect to the underlying's price. When the option being measured is deep in or out of the money, gamma is small. When the option is near or at the money, gamma is at its largest. So your observation that gamma has a tendency to shoot up around the ATM strike (50% delta) and tails down the further you go OTM is correct. That is also true the further the option goes ITM. So the effect of gamma will have a large impact on any option strategy that is close or ATM as it gets closer to profitability. In respect to traders like myself that sell premium for income, gamma and vega are major culprits in turning a profitable trade into an unprofitable trade as the position gets closer to expiration, as volatility rears its ugly head. Since I usually trade credit spreads, gamma can cause me to lose money regardless of the direction the underlying moves when IV rises, especially when the moves are of the "flash" type. If I can control those Greeks I have a much better chance of profitability than if I don't .

[@dallin_stagg]

If the underlying moves, are we still hedged with respect to all three Greeks?

[@MacGuffin1234]

If the underlying moves, the Greeks change and we aren’t as hedged. We must rebalance our position to achieve a neutral position. One thing to think about: how often do we rebalance?

[@neo-qw9wj]

Very Good video on how to hedge. The best i have seen so far. I have tried to replicate it, i think the Number of shares need to be multiplied by 100 to get the correct delta. I think in this case its 38000 for number of shares. Please correct if im not doing this right.

[@jim2344]

I am sure the purpose of hedging is to profit. Since Delta, Gamma, even Vega are all neutralized, The only way can be profit is through Theta. Now the questions is since this hedging methodology is using both options and underlying, options are mostly offset each other. The only thing left to adjust is the underlying, how often to adjust the Delta? If over adjusting Delta which can dramatically increase the commission fee and the cost of hedging (each adjust normally comes with a negative P/L ), will your overall position eventually profit? Will overall Theta P/L > total cost of hedging?

[@TheFeintOfHearts]

That is incorrect. The purpose of hedging is not to profit. I know it may sound weird, so let me explain. Hedging is protection; it's playing defense. You're not looking to make money when you hedge, you're looking to not lose money. He started off the video by saying that this is a position that the market maker was assigned by a client, meaning the MM did not necessarily want this position. This is what's called a "negative selection portfolio". The market maker didn't decide that he wanted to be short 10,000 calls, but he is providing liquidity to the counterparty that bought 10,000 calls in order for his institution to make a commission. In order to not be exposed to the risk of that position, he has to hedge it out. The market maker is not trying to make a profit on this trade; he is trying not to lose any money on this trade that he was essentially forced to take on for a client. As long as the position doesn't lose any money, then the position is a wash and the market maker has profited from commissions. That's the goal.

[@ricomajestic]

@@TheFeintOfHearts So being delta, gamma, and vega neutral would be completely useless to a retain income trader or can you use this if your position goes against you?

[@brewmaster0507]

Subscribed. Wow. Nice job.

[@mu27amaria]

Can we add or subtract non linear quantities like gamma?

[@nicobriceno732]

I don't think it's that simple because they are derivatives and are constantly changing as time passes.

[@joshuawoodford7525]

@@nicobriceno732 this covers entering the trade nuetral, you're talking about the need to manage the trade which is absolutely critical but entering Vega/delta/gamma nuetral trying to benefit from theta exclusively should cover the difference exposure in gamma unless we are in black swan events or market crashing/surging enviroments. In which case if you aren't managing properly you could get burned. Trust me when you get Vega nuetral it really helps nuetralize and stabilize your positioning and for me simplifies option trading.

[@jnnero123]

so im assuming we can collect on the theta with this?

[@ohmygoddahal]

yes, i think the point of hedging gamma is to just collect theta and nothing else, this is far less risky than selling weeklies without hedging but because you are buying the otm calls and shares, you are capping your profits to only theta. as for big rates in interest rates, i suppose you could do the same by hedging rho.

[@Pengkui]

@@ohmygoddahal Aren't options selling mainly trading gamma for theta? If gamma is fully neutralized, can you have positive theta?

[@tsunningwah3471]

love from hong kong

[@dled2010]

correct me if i'm wrong, but i'm confused a bit since each contract controls 100 shares. if i'm selling 10k contracts, and my delta is .55, doesn't this mean my delta actually 55 shares a contract making the amount i need to purchase to hedge 550k shares of the underlying? why would i only buy 5500 shares to hedge a position that controls 1 million shares? Just looking for a little clarity.

[@bionicturtle]

My example doesn't refer to contracts: mathematically, that's merely a convention to group 100 options. A single call option has a (%) delta in a range from 0 to 1.0. So, if you want to preserve my example, you can think of 10,000 options as 100 contracts. Obviously, right? If you want to assume 10,000 contracts with percentage (per-option) Δ of 0.55, then the position delta is 10,000 * 100 * 0.55 = 550,000, as you suggest. The "contract" isn't critical to this. It's just a grouping construct.

[@nicobriceno732]

hello, great video. Don't the Greeks change as time passes because they are derivatives and are not constants?... Your "Position Greek" would be the same initially but would change, simply because the greeks are derivatives and depend on other factors.

[@j.s.9981]

Yes and that means if you decide to hedge delta, gamma or vega you will need to have a plan to manage them on an ongoing basis. For example, gamma and vega are both related to changes in volatility and the impact of that volatility on delta.That is one of the problems with hedging portfolios. You can't just do it once and forget about it. I manage my entire stock option portfolio by hedging to delta and gamma neutral. I also hedge vega by putting on VIX trades, which is the implied volatility of the S&P 500. Since I beta weight my entire portfolio back to SPY it makes sense to use SPY options to hedge out delta and gamma and VIX to hedge out implied volatility. I do not worry about buying and selling long or short shares to hedge out delta to keep from using options which introduce changes to all of the other Greeks, since delta is going to change all the time anyway. You will never be perfectly hedged out to neutral on any of the Greeks, so don't worry about it. What you are trying to accomplish with these neutral hedging strategies is to optimize the profits and/or losses by not being too long or short to the market at any point in time. As long as you are in the ballpark, of being neutral you are good to go. I usually look at my hedges at the end of each week, unless I have heavy trading action during the course of the week, in which I will take a look at my positions every couple of days. All of my hedging options are set to expire at the end of each month, at which time I recognize either gain or loss by closing out the positions. I then put brand new option trades on to get my portfolio back to neutral with an expiration date at the end of the new month. So in addition to the cost of hedging, you will need to actively manage your portfolio if you are going to optimize your ability to make money in the option business. However, keep in mind, it is good when you get to the end of the month and find out your option hedges actually created a profit for you as they are closed out. That means they did their job and kept you from suffering an additional loss if you did not have the hedges on at all. As long as they are profitable, I know I more than covered my costs. When they are not profitable, it simply means that loss was the cost of the hedge to allow you to sleep better at night. The insurance was not needed since the market did not move against your open positions. It reduced the equity in your account by the amount of the loss, but to me it is worth it.

[@jnnero123]

hey jim can you tutor me please? i will pay you of course

[@MJ-cb5mk]

Don't you need to account for the 100 shares of underlying stock = 1 options contract in your calculation for position Delta & Gamma? So for your example #1 instead of -5,500 & -440 shouldn't it be $-550,000 & -$44,000? (10,000)*(100)*(-.550) & (10,000)*(100)*(-.044)? Position Delta $s and Position Gamma $s?

[@investwithvincent6329]

Excellent presentation, but i must ask. How come it makes sense to leave out Delta when setting up the system of equations? 11:25

[@dr.michaelj.stefano8113]

IT ISNT LEFT OUT. GAMMA I JUST DONE FIRST. BALANCING GAMMA LEAVES DELTA UNBALANCED, WHICH THEN IS BALANCED WITH SHARES WHICH HAVE NO DELTA OR GAMMA TO THROW IT OFF. SO GAMMA IS THE KEY TO BALANCE. THEN DELTA IS BALANCED WITH SHARES. SIMPLE.

[@Dinka2002]

isn't it too much work and money for one little call premium?

[@MQLWorld]

wow wow wow

[@isakw5039]

If the stock goes down, we lose money right?

[@intrinsicphoenix9868]

Yep. all these are done in micro seconds by the mm algos.

[@delingwei9119]

Since we are hedging both option delta and gamma. How do we make money by doing these trades?

[@TheExceptionalState]

By selling the option (eg as a bank). NB it is a hedge

[@j.s.9981]

If you are trading for income using short strategies and earning premium, you make money by unlocking the value at expiration, well before expiration. Delta neutral takes care of small changes in the underlying price, gamma neutral takes care of larger changes in the underlying price. By isolating the effect of delta, gamma and vega on the price of the options, your potential profit that would be earned at expiration is unlocked prior to expiration. In other words the only remaining Greeks that would have a potential impact on the option price, negative or positive would be Theta and Rho. Since Theta is your friend as an option seller and Rho usually has very little impact on the option's overall price,( unless you are trading underlyings that are heavily in debt or financial type of stocks) you have optimized the rate at which the option strategy makes money by hedging out the effect of the big Greek movers. What are the downsides to this strategy? 1) You need to be aware of your net delta, gamma and vega positions so you can adjust the hedge hen necessary to bring it back close to being neutral. This requires active management. 2) You need to be aware of the cost of the hedge at all times, since you need to cover that cost with the increased profits your portfolio earns. Since you more than likely already know what you are earning on your option portfolio, you will need to continue to track the results after you implement these types of hedging strategies. If it results in increased monthly and/or annual returns, you have your answer. You are covering the costs successfully. One last point I would like to make. A successful hedging strategy will also allow you to consider scaling up your positions when premium pricing is low ( times of low volatility), without losing a lot of sleep over it. This can also enhance earnings, as long as you don't tie up too large of an exposure to your portfolio in any one trade that can be detrimental to your overall portfolio profits.

[@todddavey3518]

@@j.s.9981 Thank you for the intelligent reply

[@dr.michaelj.stefano8113]

on the IV you are selling

[@migelvandevoorde9593]

thank you so much