hat do we mean by Dynamic Hedging?
One of the most important concepts in quantitative finance is that of "dynamic hedging".
Dynamic Hedging is also the title of Nassim Taleb's best selling textbook on trading and risk
management of vanilla and exotic options.
BlackScholes option pricing model tells us that a portfolio consisting of one option and
minus delta shares at any point in time is risk neutral and should yield the risk free rate of
interest. This is the principle of delta hedging. If we are long a call option then delta hedging
means selling shares and if we are long a put option then delta hedging means buying
shares (minus delta for put means buying shares because delta of a put is itself negative). In
practice, of course, we cannot have minus delta shares to hedge an option at all times. Since
stock prices change continuously we'll have to adjust the number of shares in our portfolio
continuously, which is not possible (very frequent rebalancing of portfolio will anyway cost
us a lot of money and we'll have to incur losses). Therefore, option traders rebalance their
portfolio, i.e. delta hedge at discrete points in time only. This process is known as dynamic
hedging.
Reference:
1. de Weert, Frans, Exotic Options Trading (John Wiley & Sons, 2008)
2. Taleb, Nassim, Dynamic Hedging (John Wiley & Sons, 1999)
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