As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. Now with respect to delta hedging exotic options, quoting from Lorenzo Bergomi's "chapter's digest" and adding some of my own remarks:. Please enter a valid email address.
Delta as the change in option value for a change in the underlying product price
I have also discovered that market-making in European options generally is conducted by using volatility models to project vol for some underlying asset and then quoting bid and ask prices using the pricing model subject to the projected vol and finally delta-hedging all option positions that get filled by the market.
What is the effect of delta-hedging exotic options? Does it have the same effect of turning the exotic options into volatility-based payoff products as opposed to directional price movement payoff products? Do market-makers in exotic options delta-hedge their positions just like is done with vanilla products? Consider reading Lorenzo Bergomi 's excellent book -- or at least the first chapter available here for download --, it will help you clarify things.
Now with respect to delta hedging exotic options, quoting from Lorenzo Bergomi's "chapter's digest" and adding some of my own remarks:. Dynamical trading of vanilla options, however, exposes us to uncertainty as to future levels of implied volatilities. An exposure which is usually dealt with by trading vanilla options. See for instance the case of a relative forward-start at the money call in a homogeneous diffusion model. In that very specific case, we do not care about delta hedging anymore since it is only the dynamics of forward volatility that matters.
One way want to neutralise such an exposure using calendar spreads. Delta-hedging can be seen from banks as "manufacturing the product". Banks are product manufacturers, so they delta-hedge. Exotic options are options which are not volatility-only products. They depend on volatility dynamics.
The general concept is the same. With vanilla options the point of delta hedging is to profit from volatility not directional price movements. The same does not seem to apply to exotic options. Technically, this is not a valid definition because the actual math behind delta is not an advanced probability calculation. However, delta is frequently used synonymously with probability in the options world. Usually, an at-the-money call option will have a delta of about.
As an option gets further in-the-money, the probability it will be in-the-money at expiration increases as well. As an option gets further out-of-the-money, the probability it will be in-the-money at expiration decreases. There is now a higher probability that the option will end up in-the-money at expiration. So what will happen to delta? So delta has increased from. So delta in this case would have gone down to.
This decrease in delta reflects the lower probability the option will end up in-the-money at expiration. Like stock price, time until expiration will affect the probability that options will finish in- or out-of-the-money.
Because probabilities are changing as expiration approaches, delta will react differently to changes in the stock price. If calls are in-the-money just prior to expiration, the delta will approach 1 and the option will move penny-for-penny with the stock.
In-the-money puts will approach -1 as expiration nears. If options are out-of-the-money, they will approach 0 more rapidly than they would further out in time and stop reacting altogether to movement in the stock. Again, the delta should be about. Of course it is. So delta will increase accordingly, making a dramatic move from. So as expiration approaches, changes in the stock value will cause more dramatic changes in delta, due to increased or decreased probability of finishing in-the-money.
But looking at delta as the probability an option will finish in-the-money is a pretty nifty way to think about it. As you can see, the price of at-the-money options will change more significantly than the price of in- or out-of-the-money options with the same expiration.
Also, the price of near-term at-the-money options will change more significantly than the price of longer-term at-the-money options. So what this talk about gamma boils down to is that the price of near-term at-the-money options will exhibit the most explosive response to price changes in the stock. But if your forecast is wrong, it can come back to bite you by rapidly lowering your delta. But if your forecast is correct, high gamma is your friend since the value of the option you sold will lose value more rapidly.
Time decay, or theta, is enemy number one for the option buyer. Theta is the amount the price of calls and puts will decrease at least in theory for a one-day change in the time to expiration. Notice how time value melts away at an accelerated rate as expiration approaches.
In the options market, the passage of time is similar to the effect of the hot summer sun on a block of ice. Check out figure 2. At-the-money options will experience more significant dollar losses over time than in- or out-of-the-money options with the same underlying stock and expiration date. And the bigger the chunk of time value built into the price, the more there is to lose. Keep in mind that for out-of-the-money options, theta will be lower than it is for at-the-money options. However, the loss may be greater percentage-wise for out-of-the-money options because of the smaller time value.
Obviously, as we go further out in time, there will be more time value built into the option contract.