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Earning bid/offer when delta hedging

October 14th, 2022, 6:27 am

I remember once reading about a theory that option premiums were empirically higher than the value implied from models like black-scholes as it allowed the holder of the option to capture (rather than incur) the bid/offer spread. Does anyone know what papers/books talk about such theory?
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Re: Earning bid/offer when delta hedging

October 14th, 2022, 3:04 pm

A weak spot in that kind of theory is that, ex ante, one cannot know the “true” volatility and the market consensus revealed by pricing may not be the true price – that is, the market can and does get it wrong sometimes.
It has a lot to do with market sentiment. I started trading options on CAD fixed income in the early 1990s, a time of constitutional stress in Canada over the existential Quebec French language issue. Sovereign country risk was elevated, implieds rose well above realized vols and I sold tons of options to hedgers, making serious money doing so reverse trading after subsequent political events calmed the separatist fears and implieds fell. The character of the market then completely turned, whereupon the clients then all wanted to sell options instead of buy them (after vols fell!). Some traders got sick of bidding and quit trading. But implied vols fell enough that it became profitable to buy options and delta hedge them out.
I don’t know how you build a theory around that, but one sometimes hears old school option traders say one makes more money selling options than buying. My experience was different, I didn’t care whether clients bought or sold. What I was always most happy about was when corporate clients had a similar itch and leaned the same way, the momentum thing. Maybe that’s another theory?
Let’s finish with a bit of the Socratic method. A basic rule for option trading is that when you sell options you give back some of the premium received every time you reset a delta hedge, and vice versa. Hence you want implied vol to rise after you buy an option and fall when you sell. Does a wider bid/offer spread effectively serve to increase price vol? Is that what intrigues you? Review the hedge positions necessary for short/long call/put positions. Now think about how that interacts with the bid offer spread. Can the tail wag the dog?