The

problem with delta hedging

What is delta hedging and why do it?

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Delta hedging is the process of keeping the total delta,

the rst deriva=ve of value with respect to spot price,
of a por?olio as close to zero as possible.
C
=
= ( d1 )
S
S $ 2'
ln + & r + )
K %
2 (
d1 =

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Delta hedging helps construct por?olios which do not

rely on direc=onal assump=ons about the market. In
prac=ce, many traders use delta hedging to aEempt
to mi=gate risk, since a zero delta should mean that
the value por?olio stays the same even as the market
changes. However in common circumstances, a delta
neutral por?olio is only going to be stable under small
shiGs in the market.
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Which circumstances and why?

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In general, an analy=c func=on, f(x), behaves like a

polynomial with its nth deriva=ve over n! as the
coecient on xn,
f !! ( 0 ) 2 f !!! ( 0 ) 3

f ( x ) = f (0) + f ! (0) x +
x +
x +...
2
6

This means that for large values of x, the higher order
deriva=ves become the dominant terms.
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In this case if the underlying moves a large amount,

then gamma will take over.
2C ( d1 )

= 2 =
S
S

This is especially true if gamma has a large absolute
value compared to delta, which will happen during low
vola=lity or close to expira=on.
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Fortunately, these large moves in the underlying are

less common in low vola=lity underlyings, but when
they do happen they can be tragic for those who
thought their posi=on was safe.

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Can speed come to the rescue?

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Speed, the third deriva=ve, can help to mi=gate this

since it oGen points in the opposite direc=on from
gamma.
3
'

C
$ d1

Speed = 3 = &
+1)

(
S
S %
The excep=on being for in the money puts and out of
the money calls, since for those d1 is likely to be
nega=ve, especially with low vola=lity or near
expira=on.
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This means that delta-hedging may be eec=ve as

a risk management tool when dealing with out of
the money puts and the in the money calls, but
otherwise leaves you much more vulnerable to
large moves than you might have thought,
especially unexpected or sudden large moves, the
exact sort you were probability hoping to hedge
against.
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So what should we do if we want to

hedge against the pi?alls of variance
in situa=ons where delta-hedging is
going to be ineec=ve?
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The answer, as so oGen, is to make small,

frequent, and uncorrelated trades. By keeping up
a high eec=ve number of occurrences, the
central limit theorem will help reduce the
variance that you experience on your returns, and
that works in any market condi=ons its math.
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DISCLAIMER: The purpose of this material is to demonstrate market trading techniques and strategies designed to give you the skills and condence to manage your
own investments.

The risk of loss in trading securi=es, op=ons, futures and forex can be substan=al. You must consider all relevant risk factors, including your own personal nancial
situa=on, before trading. Op=ons involve risk and are not suitable for all investors.

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