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Minyan Mailbag: Over-trading Delta Exposure


The market is much bigger than us and may take a stock much higher on sentiment, ignoring fundamentals.


Professor Succo,

I believe you once said that you thought people over-trade their delta exposure. We do not trade vol (we are fundamental investors) and I'm not sure what the pros and cons are of how frequently one adjusts their delta-hedging. I would greatly appreciate your insights and thoughts. Keep up the great work on MV.

-Minyan Charles


We normally under-trade our delta for two reasons:

First, we enter almost all of our volatility trades for fundamental reasons. We might be long volatility in a stock because we believe the stock is going down for various reasons. The trouble is, as I have mentioned, the time horizon and tolerance for risk for our investors (hedge fund) is such that shorting the stock is not tolerable. The market is much bigger than us and may take that stock much higher on sentiment, ignoring fundamentals. Our long volatility position, if we buy options cheap enough, is meant to put us in a position to be short when the stock begins to go down, perhaps from much higher levels. This allows us to break-even as we re-hedge our delta normally as the stock rises and then less often (under-trade the delta) as it begins to decline. We would do the opposite for stocks that we "like."

Second, we do believe that stocks exhibit persistence: the tendency for stocks to "trend." This is the basis of momentum trading, but my problems with momentum trading are many, the biggest being when to "get off the trend." By being long volatility (again, at the right price) and "under-hedging," we can extract the positives of momentum trading without the negatives.

We in essence then are not "pure" volatility traders, who attempt to take no view and extract only volatility.


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