Picking a hedge option

Question

In picking a hedge option, how important is it to buy one where the implied volatility isn't much higher than actual market volatility? Should one look at the option chain and find those options that have the best price in terms of implied volatility vs. actual volatility, and if need be, just buy a different number / ratio of options with the lowest implied volatility? I know this has its limits, as the delta values of the put options will be different, but just generally speaking, is there guidance/thoughts someone can provide here?

As a concrete example, with GLD currently 166, I'm looking to

• hedge a 145 Call (March option, currently 3.5 months out)
• this call is used to sell weekly calls against (vs. owning the underlying security)

There are various choices in picking a put option to hedge this call against, should GLD drop. Given the best time to enter this trade is when volatility (and ideally implied volatility) is at a relative low point overall, what additional put option characteristics might I look at in determining which option to pick, if I am free to use any number/ratio of put options against the $145 call?

Answer 1

This is a still unanswered theoretical question.

As an option seller whose strategy is not to provide liquidity through the bid ask spread, the most prudent use for options is to hedge underlyings because of the potentially enormous credit risk, that short options be fully hedged with underlying.

Seeking premium on options will limit gains but will also weaken the rate of losses. For this reason and the typical usage of the non-liquidity providing seller in this manner, academics characterize options sellers as "risk adverse" while options buyers are "risk seeking". Options buyers are risk seeking because they typically do not hedge with the underlying, exposing them to much more directional risk yet not credit risk.

Liquidity providers try to have no directional bias (more long contracts than short or vice versa).

Seeking to dynamically hedge can be disastrous as LTCM has shown. This is why liquidity providers try to hedge with other options so to have no directional bias, hedging far less greeks than without for less and cost because there's less to actually hedge or to trade to maintain the hedge.

While the underlying should be the primary concern, implied volatility levels should preferably be higher if hedging with short options, lower for long. "Then what?" goes back the theoretical problem at hand.

Answer 2

The higher the IV, the more costly the hedge. There's nothing that you can do about the IV of the options in the chain. The market determines that.

If you want, you can offset the IV by selling IV as well. So rather than buy a long put, buy a vertical spread. This might be more appropriate for hedging a long call because you are hedging a smaller amount of money, as compared to hedging the much larger cost and therefore greater risk of a long equity position. Given that you are writing diagonal call spreads, you might consider diagonalizing the put spread as well so that you can collect weekly premium on both sides.

I think that a more important consideration is simply the bang for the buck that you get for your hedge. IOW, how much call risk do you allevaiae versus what's the cost of alleviating it? Compare each put strike price and its cost (or vertical and its cost) to the amount of long call risk reduction and let that determine your choice of strike(s).

The difference in delta values per strike price is irrelevant if you're delta neutral hedging. Two 30's equals one 60.