A Quick Thought On Hedging Tail Options

These are copy/paste replies to a friend who asked my opinion on options.

1. What do you think about “hard” vs “soft” deltas? I.e treating your otm deltas differently than your atm or itm deltas. Specifically not delta hedging when you buy otm wings?My response:Depending on the name and how the skew behaves I’d say my experience in normal conditions is OTM options have lower deltas than the model predicts. The prices are “sticky”. So if I’m running a book long lots of OTM options I’m going to lean my delta in that direction.
2. What about if you get long vs short those wings? Would you treat the delta differently depending on that?My response:You can’t hedge a wing short with anything but other options so it would depend on the option hedge. In general, I don’t open selling wings just because they are “high”. I will sell expensive wings closing. Also, there’s asymmetry with respect to how you ended up with a wing position. Typically you can get long them at reasonable levels because they are the leg of a spread that’s popular in some market. For example, in oil markets, when producers buy put spreads they are handing you the wings. Yummy.

   In general, the only way I end up short wings outright is if the underlying makes a huge move through [for example] a short call spread, blowing thru both call options. Well, now I’m synthetically long a put spread and therefore short the left tail.

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