Charm-Adjusted Delta
and Delta Gamma Hedging
Miklavz Mastinsek
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M iklavz M astinsek For options that expire weekly or in general for
is a professor of math- options near expiry, the time change of the delta may
ematics in the Faculty of
become relatively large. This article analyzes the sen-
Economics and Business at
the University of Maribor sitivity of the hedging error with respect to the time
in Maribor, Slovenia. derivative of the delta referred to as charm. In the
mastinsek@uni-mb.si case where the charm is relatively large, an explicit
formula for the charm-adjusted delta can be given.
For the adjusted delta, the order of the hedging error
can be preserved, while the mean absolute value of
the hedging error and the average loss of hedging can
be reduced. Two standard hedging techniques are
considered: delta hedging and delta gamma hedging.
For practical applications, a simple adjusted standard
delta is given. An example of the European call
option is considered.
T
he Black–Scholes–Merton model
was derived on the basis of con-
tinuous time trading and riskless
hedging (e.g., Black and Scholes
[1973], Merton [1973]). Hence, inevitably,
when applied to the practical problem of dis-
crete time trading, hedging errors appear
(e.g., Boyle and Emanuel [1980]; Primbs and
Yamada [2006]).
The hedging error depends on the time
length between rebalancing as well as on higher-
­order partial derivatives like gamma, charm,
and others. There are only few articles in the
literature that in addition to the gamma also
treat other higher-order partial derivatives of
Spring 2012
JOD-MASTINSEK.indd 69
options (see, e.g., Carr [2000], Garman [1994],
Wilmott [1994]).
Clearly, when the gamma term is much
higher than the other terms of the error, then
the delta gamma hedging can substantially
improve the hedging and reduce the error.
However for options near expiry, for instance,
in the case of options that expire weekly, such
assumptions do not always hold. The hedging
error may be more sensitive with respect to
other higher-order partial derivatives, as well.
Even in the case of the European call option
near expiry, other terms of the error may be
relatively high; an example will be given later
in this article. Evidently, the hedging error can
be directly reduced by using smaller time inter-
vals between rebalancing. However, smaller
rebalancing intervals involve increased trading
frequency and thus higher transaction costs
(see, e.g., Leland [1985], Mastinsek [2006]).
To be more specific, let V = V(t,S) be the
option value as a function of time t and the
underlying assets price S. In the continuous-
time Black–Scholes model where the hedging
is instantaneous, the hedge ratio is given exactly
by the delta—the current value of the partial
derivative VS (t,S), where V(t,S) is the solution of
the Black–Scholes–Merton (BSM) equation.
We will show that additional terms dep­
ending also on the time length between rebal-
ancing may be included in the hedge ratio in
such a way that the mean absolute hedging
The Journal of Derivatives    69
2/13/12 3:43:58 PM
 error and the average loss of the hedging can be reduced.
Moreover we will show that for practical applications a
simple adjusted standard delta can be used.
DELTA HEDGING AND CHARM
Suppose that at time t a portfolio consists of a long
position in the option and a short position in N = VS (t,S)
units of stock S, so that the portfolio value Π at time t
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When ∆t is small, the hedging error will in general
be relatively small. However, when the option is near
expiry, some of the partial derivatives and the associated
terms of the hedging error may be relatively large.
Definition 2. The partial derivatives VSS (t,S) and
VSt (t,S) of the option value V(t,S) are usually referred to as the
gamma and the charm.
When S is lognormally distributed, then over the
interval of length ∆t the change of the stock can be given

is equal to
by the following:
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Π = V − VS S (1)
∆ S = S(t + ∆t ) − S(t )
With time, VS (t,S) changes. In the continuous-time where
case where the replication is perfect, the delta changes
continuously. However, in the discrete-time case, VS (t,S) S(t + ∆t ) = S(t )exp(( µ − 21 σ 2 )∆ t + σZ ∆t ) (5)
changes only at finite (discrete) time moments.
The return to the portfolio value over the interval and where µ is the expected annual drift rate, σ the
[t, t + ∆t] is then equal to volatility, and Z is a normally distributed variable with
mean zero and variance 1 (Z ∼ N(0,1)). For the details,
∆Π = ∆V − VS (t,S)∆ S (2) see Hull [2006].
We will show that even in the case of the European
If the amount Π is invested in a riskless asset (e.g., call option both the gamma and the charm term may
bonds) with an interest rate r, then over the interval of become relatively large.
length ∆t, the return to the riskless investment is equal
to Πr∆t. Example 1. Let V be the value of the European call
option and suppose that σ = 0.2, ∆t = 0.01, r = µ = 0.05,
Definition 1. The hedging error ∆H is defined as the S = $105 and E = $100, where E is the exercise price.
difference between the return ∆Π to the portfolio value and the Let T be time to expiry. Suppose that Z = 1.5, which
return to the riskless investment; that is, means that the stock value increases approximately 3%
(3) in two to three trading days. Then the values shown in
∆H = ∆Π − Πr∆t
Exhibit 1 can be obtained.
If S is lognormally distributed with volatility σ and Remark 1. Exhibit 1 shows that if the dealer is short
if V satisfies the Black–Scholes–Merton equation, then one contract (100 options), the loss due to the gamma term
the hedging error may be written as follows: as well as the loss due to the charm term will be rel­atively
1 large. For instance, if T = 0.02, the first loss will be $8.4,
∆H = VSS (t,S )(( ∆ S )2 − σ 2S 2 ∆t ) +VSt (t,S )∆t ∆S while the loss due to the charm term will be $10.9.
2
1
+ VSSS (t,S )( ∆ S )3 + O( ∆t 2 )
6
= ∆H ( SS ) + ∆H ( St ) + ∆H ( SSS ) + O( ∆t 2 ) (4) Exhibit 1
Hedging Error
where O(.) is the order of the error. (The details are given
at the end of the section.) We note that by the Black–­
Scholes equation the partial derivative VSSS can be
expressed by the partial derivatives VSS and VSt. Therefore,
we will consider first more closely the partial derivatives
VSS and VSt and the associated hedging error terms.

70    Charm-A djusted Delta and Delta Gamma H edging Spring 2012

JOD-MASTINSEK.indd 70 2/13/12 3:44:00 PM

 In general there can be many potential stock move-
ments, for which the charm term will be relatively large
compared to the gamma term. Let us illustrate this with
the following example.
Example 2. Let V be the value of the European
call option with the strike price E and suppose that
σ = 0.2, ∆t = 0.01, T = 0.05, r = 0.05. Then we have
the following:
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Proposition 2. Let σ be the annualized volatility and
r the annual interest rate of a riskless asset. Let V(t,S) be the
solution of the Black–Scholes–Merton equation:
1
Vt (t,S ) + σ 2S 2 VSS (t,S ) + rSVS (t,S ) − rV (t,S ) = 0 (7)
2
If the number of shares N(t) held short over the rebal-
ancing interval of length ∆t is equal to

Proposition 1.
N (t ) = VS (t,S ) + λVSt (t,S )∆ t (8)
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1. If S = 1.05E, then for a possible stock movement there

is a nearly 40% probability that: |∆H ( St |
)
> 21 |∆H ( SS |
)
where 0 ≤ λ ≤ 1, then the mean and the variance of the hedging
2. If S = 0.95E, then there is a 46% probability that error is of order O(∆t2 ) for all λ, 0 ≤ λ ≤ 1
|∆H ( St |
)
> 21 |∆H ( SS |
) Remark 3. Note that by Equation (8) the simple
3. If S = 1.1E, then there is a 64% probability that adjustment of the standard delta can be given:
|∆H ( St |
)
> 21 |∆H ( SS |
)

N (t ) = VS (t + λ∆t,S )
Proof: The proof is given in the Appendix.
Remark 2. Furthermore, if the hedging becomes In that case, the same order O(∆t2 ) of the hedging
less frequent and thus the time length ∆t between re- error is obtained.
hedgings increases, the associated probability for larger Proof: The change ∆S = S(t + ∆t) − S(t) of S = S(t)
errors will further increase. For the details see the proof over the interval of length ∆t can be approximated by
in the Appendix. the series expansion:
The volatility also affects the ratio between the
charm and the gamma term. According to Equation (A-3)   1  1
in the Appendix, the increase (decrease) of volatility will ∆ S = S σ Z ∆t +  µ − σ 2  ∆ t + σ 2Z 2 ∆t
decrease (increase) the ratio.   2  2
From Equation (4), it follows that the hedging error 1 3 3 2 3
 1 2 3

due to the charm term depends only on the change ∆S, + σ Z ∆t + σ  µ − σ  Z∆t  + O( ∆t 2 )
2
6  2  
when ∆t is constant. Thus it can be hedged by the same
underlying stock as the delta term. (9)
Suppose that we introduce an adjusted delta that Furthermore by Equation (9), we have:
partially or completely hedges the charm term in the
following way:   1  1  3

( ∆ S )2 = S 2  σ 2Z 2 ∆t + 2σ   µ − σ 2  + σ 2Z 2  Z∆t 2 
N (t ) = VS (t,S ) + λVSt (t,S )∆ t (6)   2  2  

+ O( ∆t ) 2
(10)
where 3
( ∆ S )3 = σ 3S 3Z 3 ∆t 2 + O( ∆t 2 ) (11)
0 ≤ λ ≤1
Hence, the change ∆V of the option value V(t,S)
In that case, the order of the mean and the vari-
over the time interval of length ∆t is equal to
ance of the hedging error remains of order O(∆t) 2. The
following result can be obtained:

Spring 2012 The Journal of Derivatives    71

JOD-MASTINSEK.indd 71 2/13/12 3:44:03 PM

 ∆V = (V (t + ∆ t,S + ∆ S ) − V (t,S )) = Vt (t,S )∆ t By assumption Z ∼ N(0,1) so that E(Z 2n ) = 1.3.5 …
(2n − 1) and E(Z 2n−1) = 0, for n = 1,2,3 … and the result
1
+ VS (t,S )∆ S + VSt (t,S )∆t∆S + VSS (t,S )( ∆ S )2 holds for all λ, 0 ≤ λ ≤ 1.
2
1 VARIANCE AND THE MEAN ABSOLUTE
+ VSSS (t,S )( ∆ S ) + O( ∆t )
3 2
(12)
6 HEDGING ERROR
and thus the change of the portfolio value is equal to Several articles on the analysis of the hedging error
have considered the problem of reducing the deviations
∆Π = Vt (t, S )∆ t + (VS (t, S ) − N (t ))∆ S
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or spread of the hedging error. Usually the mean squared

error was considered (see, e.g., Boyle and Emanuel [1980]
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3
1
+ VSt (t, S )σSZ ∆t 2 + VSS (t, S )S 2 and Wilmott [1994]). In some recent articles like that
2
of Primbs and Yamada [2006], the mean absolute error
 2 2  1  1  3

×  σ Z ∆t + 2σ   µ − σ 2  + σ 2Z 2  Z∆t 2  was considered.
  2  2   In our case with the adjusted delta we will first
1 3 consider the mean squared error.
+ VSSS (t, S )σ S Z ∆t + O( ∆t 2 )
3 3 3 2 (13)
6
Mean Squared Error
By Equation (3), it follows
For simplicity of exposition let us write ∆H more
∆H = Vt (t, S )∆ t + (VS (t, S ) − N (t ))∆ S − (V − N (t )S )r∆t concisely:
3
1
+ VSt (t, S )σSZ ∆t 2 + VSS (t, S )S 2  1 
2 ∆H = γ [(Z 2 − 1) + bZ + cZ 3 ] + φ aZ − Z 3  + O( ∆t 2 )
 3 
 (16)
× σ 2 ((Z 2 − 1) + 1)∆t + 2σ
 where
 1  1  3
 3
×   µ − σ 2  + σ 2Z 2  Z ∆t 2  1
γ = VSS (t,S )σ 2S 2 ∆t φ = VSt (t,S )σS∆t 2
 2  2   2
1 3
2( µ − 21 σ 2 ) ( σ 2 − 2r )
+ VSSS (t, S )σ 3S 3Z 3 ∆t 2 + O( ∆t 2 ) (14) b= ∆t c = ∆t a = 1 − λ
6 σ 3σ
(17)
Because by assumption, V satisfies the BSM Equation The result in Proposition 3 can be obtained.
(7), the terms appearing in (7) are canceled in (14) and the
hedging error can be expressed in the following way: Proposition 3: The minimal variance of ∆H to
the order O(∆t2 ) with respect to the parameter λ is obtained
3
1 when
∆H = aVSt (t, S )σSZ ∆t 2 + VSS (t, S )S 2
2
2γ
  1  1  3
 λ=− ( µ − r ) ∆t
×  σ 2 (Z 2 − 1)∆t + 2σ   µ − σ 2  + σ 2Z 2  Z ∆t 2  φσ
  2  2  
1 3
In that case
+ VSSS (t, S )σ 3S 3Z 3 ∆t 2 + O( ∆t 2 ) (15)
6
N (t ) = VS (t,S ) + ( µ − r )SVSS (t,S )∆ t (18)
where a = 1 − λ.
Proof: Let us denote

72    Charm-A djusted Delta and Delta Gamma H edging Spring 2012

JOD-MASTINSEK.indd 72 2/13/12 3:44:05 PM

 ∆H = γ (Z 2 − 1) + αZ + βZ 3 + O( ∆t 2 ) where
φ
α = φa + γb and β = − + γc (19)
3
Note that E(Z 2n ) = 1.3.5 …(2n − 1) and E(Z 2n−1) = 0,
for n = 1,2,3, …. Hence by (19) it readily follows
Var ( ∆H ) = E[ γ (Z 2 − 1) + αZ + βZ 3 ]2 + O( ∆t 2 )
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αβ + 2 γ 2 + O( ∆t 2 )
= α 2 + 15β 2 + 6α (20)
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The parameter α is a linear function of a. Hence we can
consider the minimal variance with respect to α: minVar ( ∆H ).
α
By (20), we find
α = −3β (21)
and thus it follows
2γ
λ = 1− a = − ( µ − r ) ∆t (22)
φσ
Consequently (18) is obtained.
Remark 4. This means, when µ = r, the Black–­
Scholes delta satisfies the minimal variance condition. An
analogous result is obtained by Wilmott [1994], how-
ever, explicit proofs are not given.
In the literature some empirical results show that
minimization of the mean squared hedging error (MSHE)
does not necessarily improve the delta hedging. For the
details, see Primbs and Yamada [2006], who compared in
their computational simulations the usual delta hedging
and the mean square optimal hedging of a European
call option.
Mean Absolute Error
Hence, instead of studying the squared error let us
consider the absolute value of error.
Note unlike the mean squared error, the mean
absolute hedging error can be given a sensible economic
interpretation: As shown previously, the mean value of
the hedging error is zero to the order O(∆t2). This means
that to the order O(∆ t2 ) the average profit P of hedging
over the interval of length ∆ t is equal to the average
loss L of hedging. Thus, the mean absolute value of the
hedging error (MAHE) is equal to
Spring 2012
JOD-MASTINSEK.indd 73
E ∆H = 2P + O( ∆t 2 ) = 2L + O( ∆t 2 )
Hence by reducing the MAHE the average profit
and loss can be reduced. By varying the number of shares
N(t) different values of the MAHE can be obtained.
Example 3. Let us illustrate this with an examples
of the option near expiry: Let V be the value of the
European call option and suppose that
σ = 0.2, ∆t = 0.01
T = 0.02, µ = r = 0.05 and S = 1.05E
where E is the exercise price and T time to expiry. In
that case we have
φ ∆t  S 1 2  
=  ln E −  σ + r  T  ≈ 1.18 (23)
γ σT  2 
Moreover we find that b = 0.03, c = −0.01, so that
the hedging error (16) is equal to:
∆H = γ (Z 2 − 1) + 0.03Z − 0.01Z 3 
+ 1.18 γ [ aZ − 13 Z 3 ] + O( ∆t 2 )
=: γF (a ) + O( ∆t 2 ) (24)
Suppose that F(a) is given by (24). Then the values
of the mean E|F(a)| of F(a) can be obtained, as given
in Exhibit 2.
In the case where σ = 0.2, ∆t = 0.01, T = 0.02,
µ = r = 0.05 and S = 1.10E, and |φγ| ≈ 2.35 and the values
shown in Exhibit 3 can be obtained.
In both cases the lowest mean absolute error
is obtained for a = 0.5. The mean absolute error for
Exhibit 2
Mean Absolute Error
Exhibit 3
Mean Absolute Error
The Journal of Derivatives    73
2/13/12 3:44:08 PM
 ordinary delta N(t) = VS (t,S) is thus 14% and in the The remaining hedging error depends on the dis-
second case 25% larger than the error where tribution of (Z − 13 Z 3 ) and on the factor (VSt + wV *St ),
which is a constant depending on specific characteristics
1  1  of used options.
N (t ) = VS (t,S ) + VSt (t,S )∆ t ≈ VS  t + ∆t,S  (25)
2  2  When ∆t is small, the hedging error in (29) will in
general be relatively small. However in some cases, espe-
We note, that by Proposition 3, when µ = r, the cially when the option is near expiry, the remaining hed­
minimal variance is obtained for a = 1. However as the ging error may be relatively large. As shown in Exhibit 1,
example shows, for options near expiry, the MAHE can it can be as large as the gamma term, which has been elim­
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be lower for other values of a. In this way the average inated.

loss can be reduced. In order to reduce the hedging error let us consider
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again the variation of the delta that depends also on higher

GAMMA HEDGING WITH CHARM order partial derivatives and on the time length ∆t. We
will show that in this way the factor (Z − 13 Z 3 ) may be
Let us assume that the portfolio can be made also changed and thus the mean absolute hedging error can
gamma neutral by including an additional derivative be reduced.
security with value V* = V*(t,S), such that it holds: Suppose that we introduce a new delta in the fol-
lowing way:
VSS + wV *SS = 0 (26)
N (t ) = VS (t,S ) + λVSt (t,S )∆ t
for some real number w (see, e.g., Hull [2006]).
N * (t ) = V *S (t,S ) + λV *St (t,S )∆ t where 0 ≤ λ ≤ 1
In that case, provided that the portfolio is made
(30)
also delta neutral, the hedging error of the new portfolio
∏* = (V + wV*) − (VS + V*S )S is equal to Then the hedging error becomes
3
∆H * = (VSt + wV *St )σSZ ∆t 2
3
 1 
∆H * = (VSt + wV *St )σS∆t 2  aZ − Z 3  + O( ∆t 2 ) (31)
3  3 
1
+ (VSSS + wV *SSS )σ 3S 3Z 3 ∆t + O( ∆t 2 )
2 (27)
6 where a = 1–λ. (The details are given in the next sec-
Let us turn back to the hedging error in (27). By tion.) Note that the expected value of the error ∆H* in
assumption, the two options satisfy the Black–Scholes– (31) will be zero to the order O(∆t2 ) for all values of a.
Merton equation. Hence by the derivation of the BSM However, the spread of the error will change. As in the
equation with respect to S, we have equalities for V: previous section, we will consider next two measures
of the deviation of the error: mean squared error and
1 1 1 mean absolute error.
VSSS (t,S )σ 3S 3 = − VSt (t,S )σS − VSS (t,S )( σ 2 + r )σS 2
6
3 3
(28) Mean Squared Error
and for V*. Inserting (28) into (27) and using (26), we First, we study the variance of (aZ − 13 Z 3 ) appearing
conclude in (31). Let us denote:
3
 1 
∆H * = (VSt + wV *St )σS∆t 2  Z − Z 3   1 
 3  W (a ) = Var  aZ − Z 3  (32)
3
 3 
1
− (VSS + wV *SS )S 2 ( σ 2 + r )σZ 3 ∆t + O( ∆t 2 )
2
3 where
23  1 3
= (VSt + wV *St )σS∆t  Z − Z  + O( ∆t 2 ) (29) 0 ≤a ≤1
 3 

74    Charm-A djusted Delta and Delta Gamma H edging Spring 2012

JOD-MASTINSEK.indd 74 2/13/12 3:44:11 PM

 Because Z∼N(0,1), we have E(Z 2n ) = 1.3.5 …
(2n − 1) and E(Z 2n−1) = 0 for n = 1,2,3, …. Hence, by
direct calculation, it follows
15
W ( a ) = a 2 − 2a +
9 to as gamma and charm, are presented. The analysis
and the minimal variance is obtained for a = 1. Because
a = 1 − λ, it follows that
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CONCLUSIONS
The results of the analysis of the hedging error with
respect to higher-order partial derivatives, in particular
with respect to partial derivatives of the delta referred
shows that in cases where the charm is relatively large,
an appropriately adjusted delta can be considered.
For instance, options near expiry may exhibit large
values of charm, which can affect the hedging error as

λ = 0 and N (t ) = VS (t,S ) (33)

much as the gamma. In that case, the charm-adjusted
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delta can be used such that the order of the hedging error
which gives the Black–Scholes delta as in the case of can be preserved, while the mean absolute hedging error
continuous hedging. and the average loss can be reduced.

Mean Absolute Error

Appendix
Second, let us consider the absolute values. As
Proof of Proposition 1. For simplicity let us denote:
shown previously, by reducing the MAHE, the average
profit and loss can be reduced. By varying the number 1
of shares N(t) different values of the MAHE can be ∆H ( SS ) = VSS (t, S )σ 2S 2 (Z 2 − 1)∆t
2
obtained. Let us denote 3
∆H ( St ) = VSt (t, S )σSZ ∆t 2 (A-1)
1
F (a ) = aZ − Z 3 (34) By the Black–Scholes–Merton formula we have:
3
1
and calculate its mean absolute values for different a. VSS (t, S ) = N ′(d1 ) ,
σS T
(Note that the analytical solution of the minimization
ln ES − ( 21 σ 2 + r )T
problem cannot be given as in the case of the variance.) VSt (t, S ) = N ′(d1 ) (A-2)
We find the following: 2σT T

Example 4. If Z∼N(0,1), then the values of the where

mean E|F(a)| of F(a) can be obtained, as shown in ln ES + ( 21 σ 2 + r )T
Exhibit 4. d1 =
σ T
The example shows relatively large variations of the x2
1 −
error. For example when a = 1 the mean absolute hedging N ′( x ) = e 2

error is 35% higher than that for a = 0.5. This means that 2π
the lower mean absolute error is obtained when λ = 0.5. and where N(x) is the cumulative probability distribution
Hence, in that case an adjusted delta equals function for a standardized normally distributed variable; see,
for example, Hull [2006].
1  1  Let us denote by k, the absolute ratio between the first
N (t ) = VS (t,S ) + VSt (t,S )∆ t ≈ VS  t + ∆t,S  two terms of the hedging error. From the formula (A-2) we
2  2 
readily get:

Exhibit 4 ∆H ( St )
∆t  S  1 2   Z Z
k= =
 ln −  σ + r  T  2 = k0 2
Mean Absolute Error ∆H ( SS )
σT  E 2  Z −1 Z −1
(A-3)

Spring 2012 The Journal of Derivatives    75

JOD-MASTINSEK.indd 75 2/13/12 3:44:14 PM

 1. Suppose first that σ = 0.2, ∆t = 0.01 and T = 0.05, and
r = 0.05 and S = 1.05E. Then it follows k 0 = 0.453 and
thus the ratio k may be relatively high for many values P (0.440 < Z < 2.275) = 2(0.318) = 0.636 ≈ 64%
of Z and thus possible movements of the stock price S.
For instance, by solving the associated quadratic ine- which ends the proof.
quations

Z 1 References
0.453 >
Z −1 2
2
Black, F., and M. Scholes. “The Pricing of Options and Cor-
porate Liabilities.” Journal of Political Economics, 81 (1973), pp.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

we find that Z satisfies the inequalities

637-659.
The Journal of Derivatives 2012.19.3:69-76. Downloaded from www.iijournals.com by NEW YORK UNIVERSITY on 07/10/15.

0.645 < Z < 1.551

From the distribution function N(x), we find
N (0.645) = 0.240, N (1.551) = 0.439
Hence the following probability can be obtained:
P (0.645 < Z < 1.551) = 2(0.199) = 0.398 ≈ 40%
Boyle, P., and D. Emanuel. “Discretely Adjusted Option
Hedges.” Journal of Financial Economics, 8 (1980), pp. 259-282.
Carr, P. “Deriving Derivatives of Derivative Securities.”
Journal of Computational Finance, Vol. 4, No. 2 (2000), pp.
5-29.
Garmann, M. “Charm School.” Risk, Vol. 5, No. 7 (1992),
pp. 53-56.

 his means that there is a nearly 40% probability that

T Hull, J.C. Option, Futures & Other Derivatives. Prentice-Hall,
a possible stock movements results in New Jersey, 2006.

1 Leland, H.E. “Option Pricing and Replication with Transac-

∆H 2 > ∆H 1
2 tion Costs.” Journal of Finance, 40 (1985), pp. 1283-1301.

2. Suppose next that Merton, R.C. “Theory of Rational Option Pricing.” Bell
σ = 0.2, ∆t = 0.01 Journal of Economics and Management Science, 4 (1973), pp.
141-183.
and
Mastinsek, M. “Discrete-Time Delta Hedging and the Black–
T = 0.05, r = 0.05 and S = 0.95E Scholes Model with Transaction Costs.” Mathematical Methods
of Operations Research, 64 (2006), pp. 227-236.
Then in the same way as above we find
Primbs, J.A., and Yamada Y. “A Moment Computation Algo-
k0 = 0.548 rithm for the Error in Discrete Dynamic Hedging.” Journal of
Banking and Finance, Vol. 30, No. 2 (2006), pp. 519-540.
and that
Wilmott, P. “Discrete Charms.” Risk, Vol. 7, 3, (1994), 48-51.
P (0.592 < Z < 1.688) = 2(0.232) = 0.464 ≈ 46%

Hence there is a 46% probability that To order reprints of this article, please contact Dewey Palmieri
at dpalmieri@ iijournals.com or 212-224-3675.
1
∆H 2 > ∆H 1
2

3. If S = 1.1E, we find

k0 = 0.918

76    Charm-A djusted Delta and Delta Gamma H edging Spring 2012

JOD-MASTINSEK.indd 76 2/13/12 3:44:16 PM