Hi guys,
I have been searching for some time for a book/document which gives a general overview of how options are hedged, specifically FX options. I am not looking for how to hedge a vanilla call/put, but rather how you can replicate a digital e.g. and how it is hedged in real life when you are hedging a portfolio of options and not just one structure. E.g. what happens when you sell a 1m EURUSD digital, do you really buy a call/bear spread or do you rather just try to buy gamma by using vanillas and then get delta neutral? What about a situation when you are close to maturity and spot is moving around the strike, what is generally done then? What do your first and higher order greeks look like in these situations?
I am looking for the same answers for barrier options, touch options, asian and lookback options, so basically for the simpler exotic options.
I know that this already goes into the direction of proprietary knowledge and people are less willing to share what they know, but maybe someone has an idea what I could look into - loads of books about FX options are rather useless, unless you care about pricing details.
Thanks
Try Taleb's Dynamic Hedging. I like this book a lot.
http://www.amazon.com/Dynamic-Hedging-Managing-Vanilla-Options/dp/04711…
Taleb is decent, gives you a little better idea what happens in real life. But, lucky for you, I am an FX Options trader so feel free to ask what you want.
For most exotics, the hedging thought process goes something like this. Your vega/gamma position is you immediate risk, so you think about covering that. Then you consider your surface position (is this giving me or paying me for risk-reversal? flies? what type of delta? what's your shadow gamma/vega? If you can tackle more than/all of these in a few vanilla trades that's what you do. You decompose the exotic into its core risks.
Let's say you got paid for a EURUSD 1m 1.25 put digital. Immediately, what is the vega impact? What is your risk reversal position? How does that change across spot?
Think about these questions and you'll likely have a pretty good idea of what vanilla trades to do. Reply with what you think.
Thanks for the replies so far. I actually got Taleb's book as well but I think that he didn't go into that much detail regarding my questions - I have to look into that again.
For being short the EURUSD 1m 1.25 digital, you are vega short above and vega long below the strike. I think you are long vanna initially and somewhere between now and 1.25 vanna flips, since you should be vanna short at the digital's strike. I hope this makes sense.
Would the vega profile not look like that of a short risk reversal, assuming the the digital's strike is where the risky's strikes are equally far away from, i.e. both 25d - strange description, but I hope you know what I mean...
The most common hedging method is using a callspread, and you actually use a callspread to price the binary in the first place. Frans De Weets exotic book is very good.
Correct, so looking at that vega profile, the vanilla trade which approximates the profile is buying options before the strike, selling below (so buying the put spread). If you do this equals, you are net buying vol also, hitting most of your bases. This doesn't mean you would necessarily do this trade to hedge, perhaps it suits or you like the fact that you essentially become long RR (in EURUSD that means long downside) as spot moves lower.
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