Sunday, November 2, 2014

intuitive - dynamic delta hedging

Q: Say you are short put in IBM. As underlier falls substantially, should you Buy or Sell the stock to keep perfectly hedged?


As underlier drops, Put is More like stock, so your short put is now more "short" IBM, so you should Buy IBM.

Mathematically, your short put is now providing additional negative delta. You need positive delta for balance, so you Buy IBM. Balance means zero net delta or "delta-neutral"

Let's try a similar example...
Q: Say you are short call. As underlier sinks, should you buy or sell to keep the hedge?

Call is Less like stock[1], so your short call is now less short, so you should drive towards more short -- sell IBM when it sinks.

[1] Visualize the curved hockey stick of a Long call. You move towards the blade.

Hockey stick is one of the most fundamental things to Bear in mind.

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