The components of the return from hedging options

In a previous paper (Galai 1977) I estimated the profits that could have been made by following a hedging strategy which consisted of a position in an option traded on the Chicago Board Options Exchange (CBOE) and an offsetting position in a fraction of a share of the underlying stock. The paper concluded that: " 1. The trading strategies based on the Black-Scholes model (Black and Scholes 1973) perform well in tests of the ex post hedge return. . . . 2. The market did not seem perfectly efficient to market makers. The ex ante returns, while usually statistically significant, show a strong tendency to be positive" (p. 195). In this article the profits from the hedging i strategies with options are further analyzed. The returns are decomposed to a few components in order to achieve a better understanding and additional insight into their character. Two main factors will be shown to combine to give the hedge return: the profits (or losses) from discrete ad-