Implied Volatility vs. Historical Volatility: Evaluating the Effectiveness of Delta-Neutral Hedging Strategies

Yimao Zhao ()
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Yimao Zhao: NewYork University, College of Art and Science

A chapter in Proceedings of the 2025 5th International Conference on Enterprise Management and Economic Development (ICEMED 2025), 2025, pp 647-656 from Springer

Abstract: Abstract Volatility estimation plays a crucial role in formulating risk management and hedging strategies in modern financial markets. In the context of option pricing, accurate volatility inputs are essential for strategies such as delta-neutral hedging, which aims to eliminate directional exposure by dynamically adjusting option and stock positions. This study empirically evaluates the effectiveness of implied volatility (IV) and historical volatility (HV) in delta-neutral hedging strategies, particularly focusing on short-term trading scenarios. By analyzing Nasdaq-100 ETF (QQQ) options, this research compares the hedging performance, transaction cost implications, and overall risk mitigation capabilities of these two volatility estimation methods. The data sample spans several months and includes daily prices of options and underlying assets. The results indicate that IV-based hedging provides greater stability and lower volatility in returns, making it more suitable for conservative investors and risk-averse market participants. Conversely, HV-based hedging strategies demonstrate higher potential returns but are accompanied by increased risk and variability in outcomes. An in-depth analysis of hedging outcomes, cumulative returns, Sharpe ratios, and rebalancing costs highlights the trade-offs inherent in each approach. Sensitivity tests under varying market volatilities further validate the robustness of IV in adapting to dynamic conditions. Practical recommendations for traders and risk managers are provided based on market conditions and risk preferences, emphasizing the importance of volatility measure selection in effective delta-neutral hedging. The findings contribute to a better understanding of optimal volatility modeling choices under real-market constraints and offer guidelines for applying these insights to both academic and professional financial contexts.

Keywords: Delta-neutral hedging; Implied volatility; Historical volatility; Transaction costs; Risk management (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:spr:advbcp:978-94-6463-811-0_68

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DOI: 10.2991/978-94-6463-811-0_68

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