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Smile‐implied hedging with volatility risk

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  • Pascal François
  • Lars Stentoft

Abstract

Options can be dynamically replicated using model‐free Greeks extracted from the volatility smile. However, smile‐implied delta and delta–gamma hedging do not achieve minimum variance in the presence of price–volatility correlation, and these strategies have shown poor performance relative to the Black–Scholes (BS) benchmark. We propose a way to extend smile‐implied option replication with volatility risk management. Large‐scale evidence on S&P 500 index options indicates that smile‐implied delta–gamma–vega hedging strategies outperform the BS approach as well as more sophisticated option hedging frameworks, including stochastic volatility and jumps.

Suggested Citation

  • Pascal François & Lars Stentoft, 2021. "Smile‐implied hedging with volatility risk," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 41(8), pages 1220-1240, August.
    • Handle: RePEc:wly:jfutmk:v:41:y:2021:i:8:p:1220-1240
    DOI: 10.1002/fut.22191
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