Difference between hedging with and without Volatility Smile
Hello, I am relative newbie to finance. What is the difference in the strategies used while hedging (delta and vega) in the presence of volatility smiles and in its absence? Is there a relatively easy non stochastic calculus text that i can refer to?
Cheers !!
Good lord, that's a bit of an ask... There are a few papers I could point you to, but they're probably not going to be easy.
Please do Martinghoul
Basically, the easiest thing for you to do is go and Google for anything that's been written by Derman on volatility regimes (characterised by different stickiness). Those should offer a decent starting point, I would think. If this isn't quite what you're looking for, shout.
If you hedge with a vol smile you'll be hedging your calls and puts at a higher vol and thus a higher delta (out of the money calls and puts will have an abs value delta closer to 50) than otherwise. Thus if you buy a call you'll be selling more futures and if you buy a put you'll be buying more futures. This has a thousand different implications both good and bad depending on the market.
If you hedge with a vol smile you'll be hedging your calls and puts at a higher vol and thus a higher delta (out of the money calls and puts will have an abs value delta closer to 50) than otherwise. Thus if you buy a call you'll be selling more futures and if you buy a put you'll be buying more futures. This has a thousand different implications both good and bad depending on the market.
agree with bobbington but it also depends on what commodity you are trading....treasury, eurodollar and FX options all exhibit a vol smile. so if you are trading those and not using a vol smile to price options then you will get picked off left and right and do nothing but blow out eventually. SPX options dont exhibit a smile, they actually have a negatively sloped vol skew where the OTM puts trade at much higher vols than OTM calls (this is why calls get crushed when spooz rallies).
There are several reasons why SPX options are priced like this (popularity of covered calls and protective puts being one, the world is long stocks always being another and the 1987 crash changed the vol surface from a smile to a more negatively skewed vol curve). Ags like wheat and corn actually exhibit a positive skew because in ags you 'crash up' not down....so i would follow the advice of Martinghoul and do some internet searching for white papers. i would just say that if you are trading something know that product inside and out.
eh? So, you started your post by new to finance and ended on.....
Thanks a ton @"Martinghoul" Derman's lecture notes are a great great place to start, learnt a lot...thanks a ton once again.
you can think of the implied volatility of a particular strike/expiry pair as indicative of the realized volatility that is expected around expiry time IF it gets near that particular strike.
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