Nassim Nicholas Taleb - Dynamic Hedging: Managing Vanilla and Exotic Options

After closing about 200,000 option transactions' (that is separate option tickets) over 12 years and studying about 70,000 risk management reports, I felt that I needed to sit down and reflect on the thousands of mishedges I had committed.

I clambered up to my attic where, during 6 entire months, I spent 14 hours a day, 7 days a week, immersed in probability theory, numerical analysis, and mathematical statistics (at a Ph.D. level). Then I began to write this book.

Like George Soros2, I believed in a greater uncertainty principle (more acute than Heisenberg's) that largely invalidates social science theories based on physics-like methodology and weakens the notion of modeling outside of the natural sciences. It ain't physics, I kept warning my trainees throughout my career.

My other argument against being scientific was that, even if it were a "science," option theory (while perhaps on the right track) would be too young to be reliable. I then needed to warn the public (and the regulators) against taking an unseasoned and new field and applying some of its still misspecified models to reality. Many of the market risks that have been well known to traders since imperial Rome (like squeezes and the snowballing liquidity holes) have not yet been rediscovered by the scientific risk managers. I am convinced that the financial system is largely threatened by the proliferation of risk management advisory services run by former scientists who bullied their way into financial markets. My intention was to downgrade hedging and risk management from the status of science to that of a craft, until further notice.

This book is about hedging the risks of standard and exotic options, as part of the larger framework of risk management. No road map was available since little has been written on this subject (in contrast to the extensive literature for valuation).

Dynamic hedging is more like medicine than biology. It is learned by gaining practical experience as well as by studying published research. The wrinkles of the marketplace often dominate other complex issues, which can lead option theoreticians onto a wrong path. Traders' lore can only be transmitted through practice. This book will meld matters of practical (not necessarily anecdotal) importance with fundamental theory.

The major theme is to present traders and risk managers with the tools to navigate around the difficult notion of manufacturing financial products through book-running. This book will introduce the arcane world of dynamic monitoring of risks. The core of dynamic hedging includes: