DELTA-RELATED RISKS OF HEDGED OPTION VOLATILITY TRADING EVEN WITH ACCURATE ESTIMATION OF THE VOLATILITY PREMIUM

Abstract

ABSTRACT When option volatility-traders believe that the implied volatility premium is higher or lower than they feel appropriate and they believe that market participants will come to the same conclusion and place trades that will actually move the option's price, the traders may explore a potentially profitable trading opportunity. When the traders set up their positions to exploit the perceived mispriced volatility premiums, they need to be aware of the possible offsetting impacts of movements in the values of other parameters which affect the price of the (perceived) mispriced options. Changes in the value of the underlying stock price is the most significant of such risk factors, hence creating delta-neutral portfolios seems prudent. However, this paper reveals an inherent disadvantage facing equity-hedged short option positions and an inherent advantage facing equity-hedged long option positions. This paper focuses on the impact of adjusting equity hedge positions on the profitability of the portfolios set up by the option volatility-traders even when their predictions of the volatility premiums are accurate. When the price change in the underlying asset is detrimental and of sufficient size, its impact on the option price may be greater than that of the expected beneficial convergence of the implied volatility to the expected volatility, and therefore result in a loss for the volatility traders. This implies that hedging delta risk is likely desirable for many risk-averse volatility traders. Keywords Option volatility-traders, implied volatility, delta-hedged, lag effect in adjusting hedged position.