← InstitutionalLesson 9 · 4:05
How often should you hedge?
Summary
You can explain the hedging error that comes from re-hedging at intervals, and weigh how it shrinks against what each hedge costs. You can compare hedging on the clock with hedging on a band, and use Leland's idea that trading costs act like a higher volatility.
Key terms
- hedging error
- The money made or lost between re-hedges, when the shares held drift away from the shares the hedge needs.
- typical miss
- One standard deviation of the hedged result across many paths, the usual size of the hedging error either way.
- bid-ask spread
- The gap between the bid and the ask, which you pay when you trade in and out.
- hedge band
- A rule to re-hedge only when the shares you need leave a set range around your hedge, such as 5 delta.
- Leland's idea
- Economist Hayne Leland's point that paying trading costs on every hedge works as if you were hedging at a higher volatility.
Check yourself
Answer each question to see why the right answer is right.
1. You sold 10 XYZ $100 calls at 30% volatility and 30% is what came. Why might your hedged result still end far from zero?
2. Across 200 example paths, the typical miss was $1,369 weekly, $539 daily and $195 at eight times a day. What pattern does the lesson point out?
3. With a 4 cent spread (you pay 2 cents a share) and a $1 commission, the month's cost was about $29 weekly, $75 daily, $200 four times a day and $348 eight times a day. How does a desk choose a hedging speed?
4. Hedging four times a day cost about $200 for a typical miss of $263. A 5 delta band (50 shares either way on 10 calls) gave a miss of $267. What did the band cost?
5. Using Leland's idea, with the example spread daily hedging makes 30% act like about 30.3%. What should a seller who hedges often do with that?
Finished the video and the quiz? .