Tuesday, March 25, 2008

Delta hedging on AMEX

FinanceProfessor.com has a nice piece on a proposed rule change to allow delta hedging to be used to compute the appropriate stock hedges for option positions on AMEX.

Link Here


The rule change states:
All options contracts listed and traded on the Exchange are subject to position and exercise limits as set forth in Amex Rules 904 and 905. Position limits restrict the number of options contracts that an investor, or a group of investors acting in concert, may own or control in one particular option class or the security or securities that underlie that option class.


And

Over the past several years, the Exchange as well as the other self-regulatory organizations ("SROs") have increased in absolute terms the size of the options position and exercise limits as well as the size and scope of available exemptions for "hedged" positions. /6/ The exemptions for hedged positions generally require a one-to-one hedge (i.e., one stock option contract must be hedged by the number of shares covered by the options contract, typically 100 shares). In practice, however, many firms do not hedge their options positions in this way. Rather, these firms engage in what is known as "delta hedging," which varies the number of shares of the underlying security used to hedge an options position based upon the relative sensitivity of the value of the option contract to a change in the price of the underlying security. /7/ The Amex believes that delta hedging is widely accepted for net capital and risk management purposes.


Why is this interesting?

Well, as students of mine should know, once we have covered Black Scholes, the appropriate hedge for an option is not 1 share of stock per option, but depends on the delta of the option - that is the sensitivity of the option to the change in the stock price. A 1 for 1 hedge is really only applicable for very in the money options. For most options, the delta is less than 1, and thus a smaller hedge is required. Remember that over hedging is not a good thing.