Option Hedging with Market Impact

Robert Almgren

New York University Courant Institute of Mathematical Sciences

Market Microstructure, Paris, Dec 2012

Outline
1. The problem 2. Formulation 3. Solution 4. Examples
Work with Tianhui Michael Li
Princeton: Bendheim Center and ORFE
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1. Option hedging (version 1)

Asset price Pt
Pt = P0 + Wt + himpacti

Final mark-to-market value

g0 (PT ) + XT PT + cash

Hedge portfolio Xt shares

Xt = X0 + Z
T

evaluate on mean and variance T

or

s ds
0

option expiry market close

time t
3

Option hedging (version 2)

Asset price Pt
Pt = P0 + Wt + himpacti
Overnight

Mark-to-market value
g0 (PT 0 ) + XT PT 0 + cash

Hedge shares Xt
Xt = X0 + Z
T

XT 0 = XT

s ds
0

Close Open T T

time t
4

Applications
1. Broker execution algorithm:
Client species and (possibly varying) Execute to achieve optimal hedge at close one direction trading (buy or sell)

2. What happens after you buy an option?

Seller must hedge What does his hedging do to price process?

Questions

1. What is a reasonable market model? 2. What do solutions look like? 3. How do they compare to Black-Scholes?

Market impact models

Two types of market impact (usually both are active): Permanent

Temporary

due to information transmission affects public market price due to nite instantaneous liquidity private execution price not reected in market

Many richer structures are possible

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Permanent impact
Xt = X0 + ZT
0

s ds

t = instantaneous rate of trading

dPt = dWt + G(t ) dt G( ) = Pt = P0 + Wt + (Xt X0 )
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Linear to avoid arbitrage (Huberman & Stanzl, Gatheral)

Temporary impact
t = We trade at P 6 Pt t depends on instantaneous trade rate t P t = Pt + H(t ) P

Require nite instantaneous trade rate imperfect hedging

Example: bid-ask spread

t P
Pt

sell at bid

buy at ask

1 t = Pt + s sgn(t ) P 2

Linear model: cost to trade t t shares

1 s sgn(t ) t 2 1 t = s |t | t 2
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Solutions with bid-ask spread cost

Ideal Black-Scholes hedge
Davis & Norman, Shreve & Soner, Cvitanic, Cvitanic & Karatzas

Target band (no-trade region)

Actual hedge holding

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Critique of linear cost model

independent of trade size

not suitable for large traders

in practice, effective execution near midpoint

spread cost not consistent with modern cost models liquidity takers act as liquidity providers

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Proportional cost model

H(t )

t = Pt + H(t ) P

concave
(empirical)

H(0) = 0
1 Linear for simplicity H( ) = 2
2

Quadratic cost:

1 H( ) t = 2

t
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Our solutions with proportional cost

Ideal Black-Scholes hedge
Grleanu & Pedersen: investment with proportional cost

pursuit

Actual hedge holding

t = h (T t) Xt target
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2. Formulation
Market model
Hedge holding: Xt = X0 +
ZT
0

s ds
Wt + (Xt X0 )

Public market price: Pt = P0 +

1 t = Pt + Private trade price: P 2

Ft = ltration of Wt
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Black-Scholes option value

g(T , p) = g0 (p) Final value specied

Intermediate values dened by Black-Scholes PDE

g(t, p), t < T,p 2 R
2

1 + g 2
Def:

00

= 0

(t, p) = (t, p) =

g (t, p)
0

(t, p) = g (t, p)
16

00

g(t,p) = option payout to trader

(t, p) = g (t, p)
g
0

(t, p) =
>0 <0
p

(t, p) = g (t, p)
g p

00

Short call
g

Short put
g

<0 <0

Long call

<0 >0
p

Long put

>0 >0
p

= sign and size of option position

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Final portfolio value

RT = g(T , PT ) + XT PT ZT
0

t t dt P

Option value

Portfolio value

Cash spent

Mark to market without transaction costs

Include permanent impact in liquidation cost:

1 2 X 2

We neglect: gives manipulation opportunities dominated by risk aversion

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Integrate by parts
RT = R0 + Xt + g (t, Pt ) dPt 0 ZT ZT 1 = R0 + Yt dPt t2 dt 2 0 0 ZT ZT = R0 + Yt dWt + Yt t dt
0 0

ZT

1 2

ZT
0

2 t

dt

1 2

ZT
0

2 t

dt

Initial value: Mishedge:

R0 = g(0, P0 ) + X0 P0 (constant) Yt = X t (t, Pt ) = Xt + g 0 (t, Pt )

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Mean-variance evaluation
RT = R0 + ZT
0

Yt

dWt +

ZT
0 0

Yt t dt

1 2

ZT
0

t2 dt

mishedge

Yt = Xt + g (t, Pt ) 6= 0
smooth innite variation

RT is random: optimize expectation and variance ERT = R0 + E ZT

0

Yt t dt

1 E 2

Var RT = complicated

ZT
0

2 t

dt

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Variance of RT
Neglect uncertainty of market impact term in comparison with price uncertainty
Var RT Var ZT
0

Yt dWt =

ZT
0

2 Yt

dt

Small portfolio size, or = market power

(Almgren/Lorenz 2007)

X/T T

price impact of trading whole position price change from volatility

(Mean-quadratic-variation Forsyth et al 2012)

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Mean-variance objective
1 Risk aversion 2 " ZT 1 2 2 inf E Yt dt 2 2 0

Running mishedge

Permanent impact

ZT
0

1 Yt t dt + 2

Temporary impact

ZT
0

2 t dt

(T = option expiration)
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Version 2: Overnight risk

T = market close today T = market open tomorrow
R
T0

= g(T , PT 0 ) + XT PT 0 = RT + YT PT 0 = RT + YT PT PT +

Z T0h
T

ZT
0

t t dt P g t, Pt
0

g T , PT

dPt

PT , have mean zero

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Version 2 objective function

Random variables
distribution depends only on PT PT mean 0, independent of FT 2 1 inf E YT P T 2 2 # ZT ZT ZT 1 1 2 2 2 + Yt dt Yt t dt + t dt 2 2 0 0 0
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"

Terminal mishedge

3. Solution
Value function
2 1 J(t, p, y) = inf E YT PT 2 s :t s T ZT ZT ZT 1 1 2 2 Ys s ds + + Ys ds s2 ds 2 2 t t t # Pt = p, Yt = y "

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Dynamic programming
HJB PDE:
0 = inf

1 = 2

1 2 y y + + Jt + 1 + 2 1 2 1 2 2 2 + Jpp + Jpy + Jyy 2 2 h i2 1 2 2 y y Jp 1 + )Jy 2 1 2 1 2 2 2 Jpp + Jpy + Jyy + Jt + 2 2

2 2

1 2

Jy + Jp

optimal control
=

1+

Jy

Jp

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1 A2 (T J(t, p, y) = 2

Ansatz: quadratic in y
t) y 2 + A1 (T t, p) y + A0 (T t, p)

A2 independent of price not consistent unless A1 constant in p h i 2 1 1 A0 1 + A2 1

2 = A 1 = A
2

00 A1

0 = A

A0 0+ 1+ i2 1 h 0 A0 + 1 + A1 2 i 2h 00 0 2 2 A2 + A0 + A1 + 2

1h

1 h

0 A1

1+

A2 i A1

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Solvable in 2 special cases

1. Constant gamma
g (t, Pt ) = g (t, P0 ) +
0 0

Pt

P0

measures position size and size

2. No permanent impact
= 0

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Constant
A1 = 0 , A0 (T

t =

h (1 + )(T

t, p) = A0 (Tt )

t) Yt

rate coefcient time constant

function of time remaining

s
2

Instantaneous mishedge

risk / temporary impact

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G = 1+

h0 =

2 T

Need G 0 and h0 -1 Permanent impact not too big

8 1 > > <tanh x + tanh (h0 ) , h(x) = 1, > > :coth x + coth 1 (h ) 0
h0 h0 h0 -1
When h<0, trade to increase mishedge (near expiration when risk is low)

1 < h0 < 1 h0 = 1 h0 > 1

trade rate 1 / mishedge

G (T-t)
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Summary of hedge strategy

Far from expiration, h=1 Near expiration

h increases if overnight risk large h decreases if overnight risk small h becomes negative (!) if no overnight risk

t =

t =

Yt h Yt

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What happens to price process?

constant
(t, Pt ) =
0

(Pt

P0 )

Yt = Xt = Xt

X0 + (Pt t = Yt

P0 ) (h = 1)

dynamic hedge
dPt =

dXt = t dt

dWt + t dt
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Combined processes
dYt = dXt + =
2 h Yt i 2 2

dPt dWt
s
2 2 2

(1 + ) Yt dt +
= 2(1 + )

2 (1 + )

def:

dZt =

Zt =

(Xt dWt

X0 ) + (Pt

P0 )

same dWt

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Combined processes
1 Pt = P0 + 1+ = P0 +
modied volatility

Yt + Zt Wt +

1+

Zt
0

(1+ )(t s)

dWs

stationary

<0: hedger is short the option 1+<1: overreaction, increased volatility >0: hedger is long the option 1+>1: underrreaction, reduced volatility
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Extensions
General
t = h(T ( t) Yt + bias term )

Restriction on sign of trading

2+

inf

solve numerically
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Restricted sign

Unrestricted strategy

Restricted strategy
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4. Possible applications

Price pinning to strike near expiration

if hedgers are net long

Intraday volume patterns

hedge near open and close

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Conclusions
Simple market impact model Explicit solution (at least for constant )
hedge position tracks toward Black-Scholes temporary/permanent linear model

Large hedger can change volatility

market impact on implied and realised vol

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