The profit and loss of an options trading strategy can be path-dependent, meaning that interim price movements, not just the final outcome, significantly influence profits and losses due to factors like dynamic hedging, early exercise risk, and volatility shifts.
A well-known example is the PnL of a delta-hedged option position, where the outcome depends on the path. Even if we estimate the realized volatility correctly, we still cannot determine the exact profit or loss, because the PnL is path-dependent.
How can we reduce this path dependency?
Reference [1] proposed the use of a laddering technique. The authors pointed out,
Laddering is a practical and effective solution to mitigate the risks of path dependency in option income strategies. Unlike single-path strategies that rely on fixed expirations and trade dates, laddering involves staggering option expirations and strike levels across different time frames. This approach reduces reliance on specific market outcomes, creating a smoother income stream and a more resilient portfolio structure.
Exhibit 28.2 highlights the significant benefits of laddering by combining one-month period for each trading day of the month. The results demonstrate that laddered strategies reduce return variability compared to single-path strategies, which depend heavily on specific market conditions at expiration. By diversifying expirations and strikes, laddering ensures a steady flow of income while minimizing the impact of adverse market events. The laddering approach may also improve liquidity, enabling portfolio managers to incrementally adjust their portfolios more effectively in response to market changes. This makes laddering an indispensable tool for managing path dependency and achieving consistent portfolio performance.
In short, the author advocates the commonly used approach of diversification, specifically, diversifying entry times and strike selections.
This approach is reasonable and widely accepted. However, we note that what the author refers to here is more accurately a mitigation of the negative outcomes resulting from “unlucky” paths. In a covered call strategy, since no dynamic hedging is performed, the final PnL depends on the terminal distribution of the underlying only. Nevertheless, the same technique applies equally to strategies that involve dynamic hedging.
Let us know what you think in the comments below or in the discussion forum.
References
[1] John Burrello, Managing Path Dependency and Balancing Yield in Option Income Strategies, In: Fabozzi, F.J., de Jong, M. (eds) Derivatives Applications in Asset Management. Palgrave Macmillan, Cham.
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