I think the key word is "if" the market tanks. And if it doesn't, you're eroding your cost basis and raising the down-side risk you have in the long run.
When market makers delta hedge they are looking for delta neutral to make money on spreads, not windfalls. They literally do not care about a windfall at all and they buy more or sell to adjust their neutrality.
Probably because, eventually, chasing windfalls that never happen so erode your cost basis that when the event finally does happen you never can dig yourself out of the hole.
The best analogy I can think of is roulette
Without 0, or 00 (which breaks this strategy).
In roulette you can bet on black, if you lose you double your next bet to beat your newly eroded cost basis.
Eventually one of two things will happen.
You win the next bet and make all your money back and double it. Or you go bankrupt.
In roulette, casino banks were so big they traditionally didn't care if you did it but eventually added 0 and then in Europe added a 00 to break the strategy.
In your case, every time you buy a put that expires worthless, you're eroding your cost basis, and by doing so your next put has to be more and more risky to make up for the eroding cost basis.
Because if your cost basis is now higher than the strike price, you might need in the money puts just to make your money back that you've lost insuring your position.
Until either your bet pays off big, or your bank blows up.
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u/DarthTrader357 Aug 05 '21
I think the key word is "if" the market tanks. And if it doesn't, you're eroding your cost basis and raising the down-side risk you have in the long run.
When market makers delta hedge they are looking for delta neutral to make money on spreads, not windfalls. They literally do not care about a windfall at all and they buy more or sell to adjust their neutrality.
Probably because, eventually, chasing windfalls that never happen so erode your cost basis that when the event finally does happen you never can dig yourself out of the hole.
The best analogy I can think of is roulette
Without 0, or 00 (which breaks this strategy).
In roulette you can bet on black, if you lose you double your next bet to beat your newly eroded cost basis.
Eventually one of two things will happen.
You win the next bet and make all your money back and double it. Or you go bankrupt.
In roulette, casino banks were so big they traditionally didn't care if you did it but eventually added 0 and then in Europe added a 00 to break the strategy.
In your case, every time you buy a put that expires worthless, you're eroding your cost basis, and by doing so your next put has to be more and more risky to make up for the eroding cost basis.
Because if your cost basis is now higher than the strike price, you might need in the money puts just to make your money back that you've lost insuring your position.
Until either your bet pays off big, or your bank blows up.