a misconception about harvesting volatility

A misconception about gamma-scalping

The final boss of all risk management is position sizing. Whether it’s owning tails, using stops, or hedging with anti-correlated assets it’s all managing your net exposure either locally or to a scenario based on shocking the portfolio.

That’s all delta-hedging to “scalp your gamma is”.

“But Kris, don’t I need to scalp the gamma to isolate the vol of an option trade?”

Technically, no.

By hedging your delta at various time intervals or as your position size breaches a threshold, you are first and foremost reducing market exposure risk. You do this because you don’t want directional p/l variance to swamp the vol-driven reason for doing the trade. A byproduct of this is your hedges “sample the vol”. If you hedge on the close every day and the market always comes back to unchanged after having large intraday ranges, you will sample a zero volatility. If you hedged intra-day you will sample a much higher volatility.

There’s no escaping the reality — every option trader experiences their own realized vol regardless of what the close-to-close volatility says unless they hedge close-to-close. If you benchmark realized volatility as close-to-close, you could think of your sampling as ‘volatility tracking error’ even though there is no “single volatility”.

Your hedges might sample the vol, but the intent is to cut risk, ie manage position size. You can appreciate this by considering the opposite extreme — you do option trades for volatility driven reasons but you never hedge.

What happens?

You are still trading vol. The expirations are the moments when you “sample” vol. The realized vol you experience is point-to-point volatility over longer stretches of time. It’s just hedging on a long interval.

You avoid that strategy not because it doesn’t isolate vol, but because it does so with unacceptable error bars. Remember, hedging is always a cost. It’s the price you pay to reduce p/l variance. If it was anything but that, then you’d have edge on your hedges and you should probably forget the options altogether and just trade deltas like a normal person.

There’s an important implication to this.

You can just trade vol without delta-hedging. To do that, you can just trade much smaller such that the error bars are acceptable. You could still do attribution as if you hedged daily to deduce whether you were doing a good job picking vol longs and shorts, but your actual results will have significant tracking error. If you are a retail trader you don’t have anyone to answer to other than your own tolerance. In Retail Option Trading, Euan explains how he trades straddles and doesn’t delta hedge. He’s not crazy. He’s just trading smaller than he would if he hedged assuming a constant risk tolerance between the 2 possible approaches.

It’s also my approach. I don’t delta hedge my PA. When I put trades on, I make sure I’m comfortable with the notional underlying dollars not just the premium.

If you run a vol business, you want to maximize throughput on your edge to maximize ROI on what you’re good at. This will prescribe delta-hedging. That’s an efficient business decision to give the stakeholders the product they want, even if it costs you expectancy (again hedging is always a cost). But it’s a misconception to believe that you must delta hedge to isolate vol. It’s just that you’ve decided the cost to cut the variance is worth it.

In sum:

• you are trading vol when you trade options regardless of whether you delta hedge
• hedging is to reduce p/l variance
• a byproduct of that hedging is reducing the tracking error to some platonic notion of realized vol (like close-to-close)
• if the tracking error is tolerable, you can accept more variance, but trade smaller

In a related note, Andy posted:

I’d buy size on that. I wouldn’t consider hedging until I got at least 6 figures of volume on my hedge. But regardless of whether I hedge, I am trading vol.