Int. J. Financial Markets and Derivatives, Vol. 3, No.

3, 2014 241

Hedging price changes in the S&P 500 options and

futures contracts: the effect of different measures of
implied volatility

Jitka Hilliard
Department of Finance,
Raymond J. Harbert College of Business,
Auburn University,
Auburn, AL 36849-5245, USA
E-mail: jitka.hilliard@auburn.edu

Abstract: We evaluate the performance of delta, delta-gamma and delta-vega

hedges on the S&P 500 futures options with a particular focus on importance of
daily volatility updating and the use of price-change implied volatility. Our
findings indicate that the hedging performance of Blacks model improves with
daily updating of implied volatility and fitted price-change implied volatility
for both calls and puts. Surprisingly, neither directly estimated implied
price-change volatility nor introduction of additional traded option to the
hedging portfolio seems to improve the hedging performance.

Keywords: delta hedge; delta-gamma hedge; delta-vega hedge; S&P 500

futures options; implied volatility; price-change implied volatility.

Reference to this paper should be made as follows: Hilliard, J. (2014)

Hedging price changes in the S&P 500 options and futures contracts: the effect
of different measures of implied volatility, Int. J. Financial Markets and
Derivatives, Vol. 3, No. 3, pp.241259.

Biographical notes: Jitka Hilliard is an Assistant Professor at the Raymond J.

Harbert College of Business of Auburn University. She received her PhD in
Finance at the Louisiana State University. Her research interests include
investments, ETFs, and option pricing.

1 Introduction

Market participants as well as businesses face uncertainties arising from the moves of the
markets, changes in interest rates, changes in currency values or prices of commodities.
Financial derivatives are instruments that can be used to manage these types of risk. The
use of financial derivatives increases every year. Derivatives based on specific stocks or
indices are traded on many exchanges including the Chicago Board of Option Exchange
(CBOE). Moreover, a large portion of derivative securities are negotiated privately.
According to the International Swaps and Derivatives Associations (ISDA) 2012 report,
the notional amount of outstanding OTC derivatives (excluding FX transactions) was
$642.1 trillion as of December 31, 2012. This represents increase by 25.6% over the
five-year period.

Copyright 2014 Inderscience Enterprises Ltd.

242 J. Hilliard

The focus of corporate risk management is to decrease the risk arising from the
volatility of cash flows and reducing the probability of financial distress (Stulz, 1996).1
According to the ISDAs 2009 Derivatives Usage Survey, 94% of worlds largest
corporations use derivatives to manage business and macroeconomic risks. There are
several benefits associated with lower volatilities in cash flow. First, the firm with lower
cash flow volatility generally has larger debt capacity and can therefore utilise the tax
benefit of debt. Second, lower volatility of cash flows may reduce expected tax liabilities
(Smith and Stulz, 1985) since the total tax is convex to revenue. The empirical evidence
on these issues is sparse. According to study of Guay and Kothari (2003), the use of
derivatives to hedge firms risk exposure is rather modest relative to their cash flows or
market value sensitivities. The findings of Graham and Rogers (2002) are consistent with
the notion that firms hedge in order to increase their debt capacity and tax benefits of
debt. However, they do not find evidence of corporate hedging for purpose of reducing
expected tax liabilities.
Firms hedge to reduce risk. The basic approach is to create a financial position in risk
factors that are negatively correlated with the core value of the firm. And ideally the
financial position would offset changes in core value. For example, a firm may hedge
changes in their cash flows due to changes in interest rates or in currency values.2 Recent
findings support also the practice of selective hedging that may actually result in
increased volatility of cash flows (Brown et al., 2006). The hedges can be created using
different instruments, such as futures, swaps or options.
The most common technique for hedging with options consists of matching one or
more partial derivatives in the core and hedging positions. The set of first and second
partials are referred to as the Greeks. If H is the derivative and x the underlying, then
H 2 H H
delta = , gamma = 2 and vega = . The result of a delta hedging is a
x x
portfolio that is insensitive to small changes in the underlying asset. The delta-gamma
hedge incorporates the second partial (curvature) in the hedging scheme, while the delta-
vega strategy additionally takes into the account changes in volatility. While the delta-
gamma and delta-vega hedging strategies should theoretically improve performance, their
advantage is partially offset by the requirement for an additional traded option in the
hedging portfolio.
More recent developments have brought about countless new pricing models, each of
them relaxing some of the assumptions of the Black-Scholes model. Examples of most
well known models include Mertons (1973) stochastic interest rate model, the stochastic
volatility models of Heston (1993) and Hull and White (1987a), Merton (1976) and
Bates (1991) jump diffusion models, the stochastic volatility and stochastic interest rates
models of Amin and Ng (1993) and Bakshi and Chen (1997a, 1997b) and the stochastic
volatility jump diffusion model of Bates (1996).
The downside of these more complex models is that they require estimation of
additional parameters. Errors in the estimated parameters then translate into the pricing
errors. The basic question is whether this model can ex ante outperform the
Black-Scholes model. That is, does the complexity of these models negate any theoretical
advantage in a real world setting? Bakshi et al. (1997) conducted a comprehensive
empirical study of competing option pricing models. They compared the hedging
performance of the Black-Scholes model with more sophisticated models including
stochastic volatility, stochastic interest rates and random jumps. Their results on S&P 500
 Hedging price changes in the S&P 500 options and futures contracts 243

index options document that stochastic volatility model outperforms other models in
hedging applications.
Despite these findings, traders on Wall Street have resisted more complex models and
rather tend to use a modified version of Black-Scholes model referred to as the
Practitioner Black-Scholes (PBS) model. The PBS model takes into account
non-constant volatilities (as assumed in the Black-Scholes model) by allowing them to
differ across maturities and moneyness. This is consistent with the volatility smile, as
noted in Rubinstein (1985, 1994). The PBS model also allows volatilities to be larger for
puts than for calls (Bollen and Whaley, 2004).
The basic output of the PBS model is the volatility surface. The implied volatility
surface is computed from option contracts with a wide array of moneyness and maturity
specifications. A continuous surface is then constructed from the grid of points by
interpolation or splines. The resulting volatility surface can be used to price options of
any desired moneyness and maturity. Berkowitz (2001) offers a theoretical justification
for the use of PBS. He claims that the PBS model is a reduced form approximation to an
unknown structural model. When recalibrated with sufficient frequency, the PBS model
yields good results. Christoffersen and Jacobs (2004) in their empirical study document
that when the estimation and evaluation loss functions are correctly defined, the PBS
model actually outperforms more sophisticated models, such as Hestons stochastic
volatility model.
In this study, we examine how different volatility measures influence out-of-sample
hedging performance and whether addition of another exchange traded option to the
hedging portfolio improves the effectiveness of hedges. We employ Blacks model and
evaluate hedging effectiveness using the historical volatility of the S&P 500 index,
implied volatility, and the price-change implied volatility. The price-change implied
volatility is volatility implied by price changes in the options (Hilliard and Li, 2013;
Hilliard, 2013). It is calculated by equating model price changes (as implied by a
binomial tree version of Blacks model) with observed price changes. Hilliard and Li
argue that since price-change implied volatility is estimated from option price changes, it
may be a preferred volatility parameter in predicting option price changes. And therefore,
it may perform better in hedging applications. They demonstrate that price-change
implied volatility shows similar time series behaviour and money and maturity biases as
price-level implied volatility.
The purpose of the study is to evaluate the performance of delta hedges, delta-gamma
hedges and delta-vega hedges on the S&P 500 futures option contracts with a particular
focus on the use of price-change implied volatility. Fundamentally, hedging depends on
matching price changes so the intuition is that price-change implied volatility should
produce a superior hedge. The calculation of price-change implied volatility is
complicated by the fact that it must be estimated from contracts that trade on consecutive
days. Therefore, this method notably decreases the size of the dataset. The applicability
of the price-change implied volatility is therefore restricted due to data. This restriction
can be mitigated at least to an extent by using the fitted value of price-change implied
volatility (Hilliard and Li, 2013). The fitted price-change implied volatility is obtained
from the regression.
pciv = + iv + , (1)
244 J. Hilliard

where pciv is the price-change implied volatility and iv is the implied volatility. To
evaluate performance of price-change implied volatility, we create hedges using both
directly estimated price-change implied volatility and fitted price-change implied
volatility.
Our findings indicate that the hedging performance of Blacks model improves with
daily updating of volatility measures for both call and put options. The best performing
hedges are hedges based on daily updated implied volatility and fitted price-change
implied volatility. The directly estimated implied price-change volatility does not seem to
improve the hedging performance. Surprisingly, introduction of additional traded option
to the hedging portfolio also does not result in better hedges for neither call or put
options.
The rest of the paper is organised as follows. Section 2 describes the data and
different volatility measures. The hedging setup is described in Section 3. Section 4
discusses the results and Section 5 concludes.

2 Data

The data for this study consists of options on the S&P 500 futures and their underlying
from January 1998 to December 2006. Data were obtained from CMEs Time and Sales
database. The S&P 500 futures contracts closely track the price movements of the S&P
500 index. They are traded on the Chicago Mercantile (CME). They are among the most
liquid of all derivative contracts with an average of more than one million contracts
traded per day in 2006. These contracts are used extensively for hedging well-diversified
equity portfolios.
Options were matched with underlying futures such that the trade of the option and
the futures of the same maturity occurred within 30 seconds. Since the volume of trades
on the S&P 500 futures is very large, the average delay between the option trade and the
corresponding futures trade was five seconds. Only options with price $0.25 and higher
were considered. The original dataset for calls and puts is described in Tables 1 and 2.
The complete dataset contains 76,544 call options and 101,010 put options. The majority
of call and put options are out-of-the-money or at-the-money. These statistics are
consistent with view that options are used as the means of relatively inexpensive
insurance or low cost speculation. The dataset contains both short and long dated options.
However, short term observations predominate.
The risk-free rate is calculated from Libor rates based on the British Bankers
Association Data. The Libor data are monthly with the shortest maturities being
overnight, one and two weeks. Daily Libor rates are obtained by interpolation and then
converted to continuously compounded yields.
The original datasets were used to identify contracts (options with the same strike
price and expiration) that traded on consecutive days. Observations consist of prices and
price changes on contracts that traded on Monday and Tuesday, Tuesday and Wednesday,
Wednesday and Thursday, and Thursday and Friday. For each day, contracts that traded
closest to 10 a.m. were selected. This is generally the period of highest liquidity. Thus,
the time delay between the option trades on consecutive days was very close to 24 hours.
 Table 1

All data 1998 1999 2000 2001 2002 2003 2004 2005 2006
Number of calls 76,544 15,049 10,876 9,406 7,663 9,549 7,686 5,570 5,576 4,979
Number of strike prices 186 79 77 80 103 99 77 52 46 58
Avg. trading difference 5 seconds 4 seconds 4 seconds 5 seconds 5 seconds 4 seconds 5 seconds 6 seconds 6 seconds 6 seconds
Maturity
130 days 46,901 10,221 6,958 5,806 4,726 4,901 4,500 3,024 3,576 3,189
31-60 days 20,138 3,242 2,533 2,261 1,876 3,377 2,208 1,855 1,456 1,330
6190 days 7,647 1,246 1,110 1,128 756 1,088 764 565 626 364
91120 days 1,801 323 264 207 298 175 209 126 105 94
121150 days 50 16 10 4 6 6 4 0 2 2
151180 days 5 1 0 0 1 1 1 0 1 0
181210 days 0 0 0 0 0 0 0 0 0 0
211240 days 2 0 1 0 0 1 0 0 0 0
Data description for calls according to years

241270 days 0 0 0 0 0 0 0 0 0 0
Moneyness
F / K 0.925 8,720 1,081 1,347 1,788 1,269 1,799 1,192 167 56 21
0.925 < F / K 0.975 31,711 6,257 4,774 4,277 3,377 3,807 2,950 2,429 1,823 2,017
At-the-money 34,519 7,394 4,495 3,221 2,892 3,564 3,295 2,889 3,849 2,920
1.025 < F / K 1.075 1,194 256 199 109 102 218 206 56 32 16
F / K 1.075 400 61 61 11 23 161 43 29 6 5
Notes: Data are American style options on S&P 500 futures and their underlying S&P 500 futures traded on the CME from January 1998 to December 2006.
Avg. trading difference refers to the average time difference between trades of the option and its underlying futures. Calls are in the money for F / K > 1.
Hedging price changes in the S&P 500 options and futures contracts
245
 246

Table 2

All data 1998 1999 2000 2001 2002 2003 2004 2005 2006
Number of calls 101,010 20,495 14,692 12,365 10,532 11,422 9,750 7,588 6,778 7,388
J. Hilliard

Number of strike prices 183 92 98 92 98 99 88 67 62 77

Avg. trading difference 5 seconds 4 seconds 4 seconds 4 seconds 5 seconds 4 seconds 5 seconds 6 seconds 6 seconds 6 seconds
Maturity
130 days 57,367 12,429 8,258 6,845 5,950 5,762 5,135 4,097 4,035 4,856
3160 days 27,801 4,952 3,918 3,352 2,619 4,043 3,034 2,331 1,800 1,752
6190 days 12,452 2,193 2,092 1,786 1,408 1,317 1,293 947 826 600
91120 days 3,227 853 408 367 545 272 286 206 115 175
121150 days 126 58 22 9 5 20 1 5 2 4
151180 days 29 9 3 3 5 7 1 0 0 1
181210 days 6 1 1 1 0 1 0 2 0 0
211240 days 0 0 0 0 0 0 0 0 0 0
Data description for puts according to years

241270 days 2 0 0 2 0 0 0 0 0 0
Moneyness
F / K 0.925 333 47 13 96 116 43 18 0 0 0
0.925 < F / K 0.975 1,358 285 119 198 316 154 69 58 16 43
At-the-money 29,562 5,798 3,496 3,049 2,941 3,263 2,872 2,848 2,742 2,553
1.025 < F / K 1.075 29,368 5,859 4,027 3,547 2,678 2,754 2,804 2,502 2,314 2,883
F / K 1.075 40,389 8,506 7,037 5,475 4,481 5,108 3,987 2,180 1,706 1,909
Notes: Data are American style options on S&P 500 futures and their underlying S&P 500 futures traded on the CME from January 1998 to December 2006.
Avg. trading difference refers to the average time difference between trades of the option and its underlying futures. Puts are in the money for F / K < 1.
 Hedging price changes in the S&P 500 options and futures contracts 247

2.1 The volatilities

We compare the hedging performance of several different volatility measures: implied
volatility, price-change implied volatility and historical volatility. We investigate both
out-of-sample averages of these measures and their daily updated estimates. To simplify
the orientation in the text, hereafter we will use the following abbreviations for different
volatility measures: IV for implied volatility, PCIV for price-change implied volatility,
AV500 for the average volatility of the S&P 500 index, AVIV for the average implied
volatility, AVPCIV for the average price-change implied volatility and FPCIV for fitted
price-change implied volatility.
To ensure out-of-sample testing, the sample period is divided to two parts: the
estimation period from January 1998 to December 1998 and the testing period from
January 1999 to December 2006 (description statistics for data used for regression in the
testing period is shown in Table 3).
Table 3 Description of datasets used for hedging exercise

Number of Number Maturity in days Moneyness

options of strikes 130 3160 6190 91120 X1 X2 ATM X3 X4
Calls 8,098 161 4,585 2,367 1,017 129 1,192 3,488 3,253 141 24
Puts 11,008 151 5,766 3,346 1,697 199 61 131 2,843 3,094 4,879
Notes: Data are pit-traded American style options on S&P 500 futures and their
underlying futures traded on CME from January 1999 to December 2006.
Dataset Calls (Puts) contains calls (puts) with the same strike price and expiration
that traded on consecutive days (Monday and Tuesday, Tuesday and Wednesday,
Wednesday and Thursday or Thursday and Friday). The symbol X1 in moneyness
stands for F / K 0.925; X2 for 0.925 < F / K 0.975, ATM for at-the-money, X3
for 1.025 < F / K 1.075 and X4 for F / K 1.075, where F is the price of the
futures contract and K is the option strike price. Calls (puts) are in-(out-of-)
the-money for F / K > 1.

2.1.1. Price-change implied volatility

The price-change implied volatility is a volatility parameter that equates the observed
price change of the option C with the price change implied by the model Cm, i.e.,
C = Cm ( Ft + h , T h ) Cm ( Ft , T ) . (2)

In this case the model prices are calculated using the binomial tree since the S&P 500
futures options are American options. Using the same methodology as in Hilliard and Li
(2013), the price-change implied volatility is estimated for one day price changes using
the bisection method.
The fitted price-change implied volatility refers to the price-change implied volatility
calculated from the estimated relation with implied volatility.3

2.1.2 Volatility averages

We estimate AVIV, AVPCIV and AV500 during the estimation period and use these
averages to set up hedges in the tested period. Estimated volatility averages are shown in
Table 4. Three main observations can be made with respect to volatility averages. First,
248 J. Hilliard

volatility averages estimated from puts are larger than those estimated from calls. This is
consistent with empirical findings of Bollen and Whaley (2004) and Hilliard and Li
(2013). Clearly, under the assumption of the Black-Scholes model the volatilities
estimated from puts and calls should be the same. Theoretical explanation of observed
differences is based on different demand curves for calls and puts (Bollen and Whaley,
2004; Grleanu et al., 2009; Doran et al., 2013). Puts on index futures, especially
out-of-the money puts, are in large demand by investors who wish to hedge their market
exposure. This demand creates upward pressure on their prices and leads to larger
implied volatilities estimated from put options. Second, consistently with Hilliard and Li
(2013), the difference between volatilities estimated from puts and calls is more
pronounced for price-change implied volatility than for price-level implied volatility.
This may indicate that the market imperfections that cause observed volatility spreads
have greater effect on price-change than price-level implied volatility. Third, the
historical volatility of S&P 500 index differs from implied volatilities. The historical
(realised) volatility represents an ex post measure of volatility while implied volatility is
ex ante volatility. The weighted averages of both price-change and price-level implied
volatilities are larger than the historical volatility of S&P 500 index.4 Similar differences
have been documented for example by Doran and Ronn (2005) for the S&P 500 and S&P
100 stock market indices and their options.
Table 4 Volatility averages

Average of Average of Historical

Number of records
price-change price-level implied volatility of S&P
used for estimation
implied volatility volatility 500 index
Calls 372 0.1732 0.1958 0.2449
Puts 531 0.3251 0.3016 0.2449
Note: Averages of different measures of volatilities were estimated from the S&P 500
future options from January 1998 to December 1998.

2.1.3 Volatility updating

In addition to using volatility averages, we also update volatilities daily. This means we
estimate the IV and FPCIV for a specific contract. When using IV to compute the hedge,
the volatility is estimated when the hedge is initiated and hedge results are calculated on
the following day. For example, if the one day hedge is initiated on Monday, contract IV
is estimated on Monday and hedge results are calculated on Tuesday. For FPCIV, we
estimate the relation between the PCIV and contract IV during the estimation period
(Table 5). Then we use this relation to calculate the FPCIV from IV when the hedge is
initiated.
We also update PCIV directly. A valid observation requires that a contract trade on
three consecutive days. For example, PCIV would be estimated based on the price
changes of the option and its underling futures from Monday to Tuesday. The hedge is
initiated on Tuesday and the out-of-sample observation is the hedge error observed on
Wednesday. Identifying contracts that trade on three consecutive days leads to smaller
dataset. Therefore, hedges set up with daily updating of PCIV are executed on a smaller
dataset (590 observations for calls and 718 observations for puts).
 Hedging price changes in the S&P 500 options and futures contracts 249

Table 5 Fitted price-change implied volatility

Number of records
Adjusted R2
used for estimation

Calls 372 0.1268*** 0.2375*** 0.0166

Puts 531 0.0163 1.1316*** 0.5525
Notes: The relation between price-change implied volatility and implied volatility is
estimated for data from January 1998 to December 1998. The estimation model is
pciv = + iv, where pciv is the price-change implied volatility and iv is the
implied volatility. ***Refers to significance at the 99% level.

3 Hedging price changes

Suppose that a position in an over-the-counter option is to be hedged by the underlying

asset. The typical strategy consists of establishing a short synthetic portfolio with a delta
that matches that of the option. Under Blacks assumptions, this strategy gives risk-free
yields when the position is dynamically adjusted at each instant to maintain the match.
Continuous hedging is not possible because of institutional features and is not economical
in any case because of high transactions costs.
In fact, there are several possible sources of hedging error. These errors are the result
of discrete schemes, the omission of additional state variables and stochastic process risk.
Because hedges are adjusted at discrete time increments, second order changes in the
price of the underlying contribute to both drift and volatility. This effect is sometimes
mitigated by including a second option that is exchange traded in the hedging portfolio.
This option has an exercise price that differs from that of the option being hedged.
Positions in the synthetic portfolio are determined so that both the delta and gamma of
the synthetic portfolio match that of the option to be hedged. This strategy is referred to
as delta-gamma hedging.
Another significant source of error in an equity hedge is the omission of a second
state variable such as stochastic volatility. This error can be addressed by adding an
exchange traded options that is chosen to match vega.5 This strategy is referred to as
delta-vega hedging.
Adding two exchange traded options to the synthetic portfolio to account for
discreteness and stochastic volatility is referred to as delta-gamma-vega hedging. The
setup for the synthetic hedging portfolio (V) is as follows:

V = 1 f + 2 X + 3Y + B (3)

dV = 1dF + 2 dX + 3 dY + rB, (4)

where f is the value of the underlying futures contract, F is the futures price, r is the risk
free rate, X and Y are exchange traded options and B is a default-free bond. Matching
delta, gamma and vega implies:
250 J. Hilliard

1 XF YF 0 1 CF

0 X FF YFF 0 2 CFF
= (5)
0 X Y 0 3 C

0 X Y B 1 C

where C is the option to be hedged. The first row matches delta, the second row gamma,
the third row vega and the fourth row establishes the zero-financing condition. Solutions
are as follows:

v v
XF XF A B
1 CF C F + CF + C CF + CFF + C
X FF X D D
CFF Y Y
2 0 0 CFF FF C (6)
X FF D D
C X Y
3 0 0 CFF + FF C
X D D
B C C 2 X C 3 X C 2 X 3Y

where A = XFY + XYF; B = XFYFF XFFYF and D = XFFY + YFFX:

3.1 Test setup

We examine the delta hedge, the delta-gamma hedge and the delta-vega hedge using a
variety of volatility inputs. The delta-gamma-vega hedge requires that the underlying and
two exchange traded options trade on consecutive days. The dataset and filters used did
not produce a sufficient number of observations to consider a reliable test of the
delta-gamma-vega hedge.

3.1.1 Error metrics

The hedging performance is evaluated based on several error metrics standard in the
literature. They are:

Average Error : e =
e (7)
n

Average Absolute Error : e =

e (8)
n
e
Average Relative Error : erel = 100% (9)
C
var(e)
Relative Volatility : R 2 = 1 , (10)
var(dC )
 Hedging price changes in the S&P 500 options and futures contracts 251

where dC is the option price change and C is the average price of option hedged.

3.1.2 Delta hedge

The delta hedge consists of the underlying asset and a risk free bond. The hedging
portfolio is formed on day one using parameters available or estimated on day one (when
the hedge is initiated). Then, the hedge is liquidated on day two. The price change in the
hedging portfolio dV = CFdF + rB is recorded and the hedging error is calculated as
e = dC +dV; where dC is the observed change in the price of the hedged option.

3.1.3 Delta-gamma hedge

The delta-gamma hedge consists of the underlying, risk free bond and an additional
traded option. We denote the option to be hedged as the target option.
The second traded option that is used for hedging is denoted as the instrumental
option. The hedging requires that each target option C1(S, K, T) is paired with an
instrumental option C2(S, K*, T). We find an instrumental option such that the value of
hedging portfolio must be computed at approximately the same time as the option to be
hedged (the difference between the trade of the instrumental and target option cannot
exceed 30 minutes). We choose the instrumental option to be an option with the same
maturity T, but different strike price K*. When more than one option is available, we
choose an option that trades closer to at-the-money.
The hedging portfolio is created on day one using parameters from day one and the
hedge is liquidated on day two. The price change of the hedging portfolio is:

X CFF C
dV = CF + F CFF dF dX + r C + FF X . (11)
X FF X FF X FF

The hedging error is calculated as:

e = dC + dV . (12)

3.1.4 Delta-vega hedge

The delta-gamma hedge consists of the underlying, a risk free bond and one instrumental
option. The approach is analogous to the delta-gamma hedge. The change in the value of
hedged portfolio is:

X C C
dV = CF + F C d F dY + r C + X . (13)
X X X

The same error metrics are calculated as for delta and delta-gamma hedges.

4 Results

Tables 6 and 8 give results of the delta hedge, the delta-gamma hedge and the delta-vega
hedge for calls. The corresponding results for puts are given in Tables 7 and 9.
252 J. Hilliard

Table 6 Hedging results for call options

Average Average Relative
Average
Model absolute relative volatility
error
error error (R2)
Panel A: delta hedges
Average of price-change implied volatility 0.0643 0.8760 7.16% 0.9069
Average of implied volatility 0.0820 0.9269 7.58% 0.9039
Average of S&P 500 index volatility 0.1178 1.1303 9.24% 0.8702
Contract implied volatility 0.0890 0.7678 6.28% 0.9243
Fitted price-change implied volatility 0.0674 0.8201 6.71% 0.9167
Price-change implied volatility (directly 0.0264 0.8851 8.55% 0.8497
Panel B: delta-gamma hedges
Average of price-change implied volatility 0.0312 0.9024 7.14% 0.9818
Average of implied volatility 0.0304 0.8576 6.78% 0.9858
Average of S&P 500 index volatility 0.0240 0.8666 6.85% 0.9864
Contract implied volatility 0.0490 0.7910 6.26% 0.9879
Fitted price-change implied volatility 0.0464 0.8397 6.64% 0.9865
Panel C: delta-vega hedges
Average of price-change implied volatility 0.0331 0.9023 7.13% 0.9818
Average of implied volatility 0.0324 0.8570 6.78% 0.9858
Average of S&P 500 index volatility 0.0261 0.8667 6.85% 0.9864
Contract implied volatility 0.0522 0.8091 6.40% 0.9874
Fitted price-change implied volatility 0.0511 0.8463 6.69% 0.9863
Panel D:
Unhedged position 0.2990 2.5506
Notes: Data used for the out-of-sample hedging exercise are American style call options
on S&P 500 futures traded on the CME from January 1999 to December 2006.
The hedging portfolio is created on day one using parameters known at that time.
The price change in the hedging portfolio and error metrics are calculated on day
two. A detailed description of the hedges is found in Section 3.1.
Table 7 Hedging results for put options
Average Average Relative
Average
Model absolute relative volatility
error
error error (R2)
Panel A: delta hedges
Average of price-change implied volatility 0.1210 0.7938 6.44% 0.9338
Average of implied volatility 0.1163 0.7743 6.27% 0.9338
Average of S&P 500 index volatility 0.1034 0.7807 6.33% 0.9317
Contract implied volatility 0.0940 0.6222 5.04% 0.9504
Fitted price-change implied volatility 0.0982 0.6305 5.11% 0.9503
Price-change implied volatility (directly 0.1750 0.6892 6.92% 0.9311
Notes: Data used for the out-of-sample hedging exercise are American style put options
on S&P 500 futures traded on the CME from January 1999 to December 2006.
The hedging portfolio is created on day one using parameters known at that time.
The price change in the hedging portfolio and error metrics are calculated on day
two. A detailed description of the hedges is found in Section 3.1.
 Hedging price changes in the S&P 500 options and futures contracts 253

Table 7 Hedging results for put options (continued)

Average Average Relative
Average
Model absolute relative volatility
error
error error (R2)
Panel B: delta-gamma hedges
Average of price-change implied volatility 0.0421 0.7585 9.80% 0.9523
Average of implied volatility 0.0237 0.7758 10.03% 0.9350
Average of S&P 500 index volatility 0.0792 0.9072 11.73% 0.7295
Contract implied volatility 0.0482 0.6585 8.51% 0.9739
Fitted price-change implied volatility 0.0548 0.6532 8.44% 0.9756
Panel C: delta-vega hedges
Average of price-change implied volatility 0.0451 0.7603 9.83% 0.9521
Average of implied volatility 0.0260 0.7789 10.07% 0.9331
Average of S&P 500 index volatility 0.0989 0.9314 12.04% 0.6134
Contract implied volatility 0.0611 0.6931 8.96% 0.9758
Fitted price-change implied volatility 0.0674 0.6931 8.96% 0.9766
Panel D:
Unhedged position 0.2381 2.4698
Notes: Data used for the out-of-sample hedging exercise are American style put options
on S&P 500 futures traded on the CME from January 1999 to December 2006.
The hedging portfolio is created on day one using parameters known at that time.
The price change in the hedging portfolio and error metrics are calculated on day
two. A detailed description of the hedges is found in Section 3.1.
Table 8 Comparison of hedging results for call options

Average of Fitted
Average of Compact
S&P 500 price-change
Model implied implied
index implied
volatility volatility
volatility volatility
Panel A: delta hedges
Average of price-change implied Yes Yes Yes No
volatility
Average of implied volatility Yes No Yes
Average of S&P 500 index Yes Yes
volatility
Contract implied volatility Yes
Panel B: delta-gamma hedges
Average of price-change implied No No No No
volatility
Average of implied volatility No No No
Average of S&P 500 index No No
volatility
Contract implied volatility No
Notes: Yes (no) means that the difference between the hedging errors for different
volatility measures was (was not) significant at the 0.05 level. The significance of
these differences was tested using a paired students t-test.
254 J. Hilliard

Table 8 Comparison of hedging results for call options (continued)

Average of Fitted
Average of Compact
S&P 500 price-change
Model implied implied
index implied
volatility volatility
volatility volatility
Panel C: delta-vega hedges
Average of price-change implied No No No No
volatility
Average of implied volatility No No No
Average of S&P 500 index No No
volatility
Contract implied volatility No
Notes: Yes (no) means that the difference between the hedging errors for different
volatility measures was (was not) significant at the 0.05 level. The significance of
these differences was tested using a paired students t-test.
Table 9 Comparison of hedging results for put options

Average of Fitted
Average of Contract
S&P 500 price-change
Model implied implied
index implied
volatility volatility
volatility volatility
Panel A: delta hedges Yes Yes Yes Yes
Average of price-change implied Yes Yes Yes
volatility
Average of implied volatility No No
Average of S&P 500 index Yes
volatility
Contract implied volatility
Panel B: delta-gamma hedges
Average of price-change implied No No No No
volatility
Average of implied volatility No No No
Average of S&P 500 index No No
volatility
Contract implied volatility No
Panel C: delta-vega hedges
Average of price-change implied No No No No
volatility
Average of implied volatility No No No
Average of S&P 500 index No No
volatility
Contract implied volatility No
Notes: Yes (no) means that the difference between the hedging errors for different
volatility measures was (was not) significant at the 0.05 level. The significance of
these differences was tested using a paired students t-test.
 Hedging price changes in the S&P 500 options and futures contracts 255

4.1 Calls
In the discussion that follows, we focus primarily on the average absolute error metric
[equation (8)] and the average relative error metric [equation (9)]. The average relative
metric is perhaps most commonly used because it is more easily interpreted since it is in
percentages.

4.1.1 Delta hedges

The ranking of hedges according to the average absolute error and average relative error
metrics are as follows:

1 hedges based on contract implied volatility

2 hedges based on fitted price-change implied volatility
3 hedges based on average price-change implied volatility
4 hedges based on average implied volatility
5 hedges based on average of S&P 500 index volatility.
The average absolute errors range between $0.77 for hedges based on contract
implied volatility to $1.13 for hedges based on the average of S&P 500 index volatility
compared to $2.55 for an unhedged position. To examine whether these differences are
statistically significant, we conduct a paired t-tests. Results are summarised in panel A of
Table 8.
Ex ante, one would expect that daily updated volatilities would provide the best
hedging results. Results are consistent with this notion. Generally, hedges using
daily updated volatilities (contract implied volatility (IV) and fitted price-change
implied volatility (FPCIV)) outperform hedges using volatility averages. The worst
performance of all volatility measures give hedges based on the average of S&P 500
index volatility.
As an illustration, panel A of Table 6 also shows hedging results for directly
estimated price-change implied volatility. It is important to note that this hedging
exercise is conducted on a smaller dataset (590 observations). It is because three
consecutive observations on the same contract have to be present for this set up. For
example, to initiate the delta hedge on Tuesday, we need a record on the same contract on
Monday and Tuesday to estimate the price-change implied volatility and then also
observation on Wednesday to evaluate the hedge. Although the results of hedges based
on directly estimated price-change implied volatility cannot be fairly compared to other
hedges due to sample size differences, it appears that using directly estimated
price-change implied volatility does not produce any advantages.

4.1.2 Delta-gamma and delta-vega hedges

Results for delta-gamma and delta-vega hedges are shown in panels B and C of Tables 6
and 8. These results suggest that including additional traded option in the hedging
portfolio does not improve the hedging performance and there is no sufficient evidence of
improvement from daily updating of volatility estimates.
256 J. Hilliard

4.2 Puts
Theoretically, the performance of put hedges should not differ from that of call hedges.
The underlying process is assumed to be geometric Brownian motion and the pricing
models are built on the same assumptions. However, point estimates of implied put
volatilities are about 50% larger than implied call volatilities. Therefore, expectations are
that the performance of put hedges is likely to be notably different.

4.2.1 Delta hedges

Results for delta hedges for puts are given in Table 7 (panel A) and Table 9 (panel A).
Delta hedges for puts have generally lower average relative errors and average absolute
errors than calls. The best performing delta hedge for puts has relative error 5.04%,
versus 6.28% for the best performing call hedge and the average absolute error of $0.62
compared to $0.77 for call hedge.
The ranking of delta hedges for puts based on the average absolute error metric are as
follows:
1 hedges based on contract implied volatility
2 hedges based on fitted price-change implied volatility
3 hedges based on average of implied volatility
4 hedges based on the average of the S&P 500 index volatility
5 hedges based on the average of price-change implied volatility.
Similarly to calls, delta hedges set up using daily updated volatility parameters
outperform hedges using average volatilities. Delta hedges based on directly estimated
price-change implied volatility do not seem to produce better hedging results than hedges
based on daily updated implied volatility or fitted price-change implied volatility.

4.2.2 Delta-gamma and delta-vega hedges

Delta-gamma (Table 7, panel B and Table 9, panel B) and delta-vega (Table 7, panel C
and Table 9, panel C) hedges for puts are slightly more effective than the corresponding
hedges for calls. However, the differences in hedging effectiveness between delta and
delta-gamma or delta-vega hedges are not significant for any of used volatility measures.

5 Conclusions

This study compares the performance of hedges based on different volatility measures in
out-of-sample hedging applications. The volatility measures used are historical volatility
and averages of implied volatility and price-change implied volatility. In addition to these
measures, hedges are also formed using daily updated implied volatility, fitted
price-change implied volatility and directly estimated price-change implied volatility.
Data used for this study are options on the S&P 500 futures contract from January
1998 to December 2006. The data are divided to two periods: an estimation period
(January 1998 to December 1998) and out-of-sample testing period (January 1999 to
 Hedging price changes in the S&P 500 options and futures contracts 257

December 2006). First, volatility averages and the relation for calculation of fitted
price-change implied volatility are estimated. Then the hedging performance using each
volatility measure is evaluated during the out-of-sample testing period. The hedges are
set up on day one using Greeks calculated based on parameters estimated at that time.
The hedges are liquidated on day two and hedging errors are quantified using standard
metrics.
As expected, delta hedges using daily updated volatilities consistently outperform
average volatilities for both calls and puts. Daily updated implied volatility significantly
outperforms both daily updated fitted price-change volatility as well as directly estimated
price-change implied volatility. Hilliard and Li (2013) find that price-change implied
volatility results in superior performance only when it is used to create volatility surfaces
that are adjusted for moneyness and maturity biases as is common in the PBS model.
When volatility surfaces are not used, a traditional daily updated price-level implied
volatility produces significantly better hedging results than fitted implied price-change
implied volatility or price-change implied volatility. As has been documented by Hilliard
and Li, we find that the performance of hedges is better for puts than for calls.
Our results also indicate that a simple approach of updating implied volatility
estimates is the most effective way to creating hedges. Although theoretically correct,
more complicated hedges, such as delta-gamma and delta-vega hedges, do not improve
the hedging performance. This is probably the manifestation of non-constant volatilities
and errors resulting from volatility estimation, missing variables and model limitations.
Hull and White (1987b) compared hedging performance of delta and delta-gamma
hedges for hedging currency risk with currency options. They found that delta-gamma
hedges perform well only in situations when implied volatility of the traded option is
fairly constant and time-to-maturity short. Under other circumstances, i.e., non-constant
volatility and long time-to-maturity, delta hedges outperform delta-gamma hedges. For
S&P 500 futures options, both price-level and price-change implied volatilities exhibit
strong time and moneyness biases. Our results therefore are not inconsistent with their
findings.

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 Hedging price changes in the S&P 500 options and futures contracts 259

Notes
1 Corporate use of derivatives can be also aimed to increase firms risk. The argument behind
the use of derivatives for the purpose of seeking additional risk is based on the agency
problem between the shareholder and debtholder (Jensen and Meckling, 1976; Myers, 1977).
The shareholders have incentives to increase the risk of the firm to transfer wealth from the
debtholders.
2 See, for example, Froot et al. (1993), Allayannis and Weston (2001), El-Masry (2006), and
Samitas and Tsakalos (2010).
3 The relation of implied price change volatility with implied volatility is estimated according to
the equation (1).
4 The weighted averages of price-level and price-change volatilities are 0.2580 and 0.2625
compared to 0.2449 for historical volatility of the S&P 500 index for the period of January
1998 to December 1998.
5 Vega is the rate of change in the price of an option with respect to volatility bond.