Put Option Payoff Replication (Dynamic Hedging)
How can the put option be duplicated?
The replicating portfolio to value a put option is a short position in the stock and purchase of a bond. This portfolio is called a replicating portfolio because if you sold the stock now (quantity discussed below) and lent the present value of the stock, your payoff will exactly match the payoff from the put option.
What does dynamic hedging mean?
Dynamic hedging. A strategy that involves rebalancing hedge positions as market conditions change; a strategy that seeks to insure the value of a portfolio using a synthetic put option.
What is static option replication?
Static replication decomposes a target option into a portfolio of standard options. The market value of the portfolio provides a practical estimate for the fair value of a target option.
What is static hedging?
A static hedge is a type of hedge that does not require investors to rebalance it actively. It means that investors do not take steps to adjust these hedges when some characteristics of their securities change.
How can you replicate the payoffs of a put option on a stock?
It is possible to replicate the payoffs to a particular stock position with the appro- priate positions in option contracts. That is, one can replicate the payoffs to a long stock position by holding a call option and selling a put with the same strike price and expiration date.
Why is it impossible to arbitrage using the put-call parity?
Put-call parity doesn’t apply to American options because you can exercise them before the expiry date. If the put-call parity is violated, then arbitrage opportunities arise.
How do dealers hedge put options?
The dealer will hedge their long call exposure by selling the underlying index, and will hedge their short put exposure by also selling the underlying. However, as the puts are currently far out of the money, the delta of these options is low and thus does not require significant hedging by the dealer.
How do you delta hedge a put option?
You can use delta to hedge options by first determining whether to buy or sell the underlying asset. When you buy calls or sell puts, you sell the underlying asset. You buy the underlying asset when you sell calls or buy puts. Put options have a negative delta, while call options have a positive.
How do you hedge a call option with a put option?
Call Option Hedge Calculation
You can use a put option to lock in a profit on a call without selling or executing the call right away. For example, the XYZ call buyer might purchase a one-month, $50-strike put when the shares sell for $50 each. The cost of the put might be $100.
Should I hedge with puts?
As a rule, long-term put options with a low strike price provide the best hedging value. This is because their cost per market day can be very low. Although they are initially expensive, they are useful for long-term investments.
How do you hedge a long put option?
To hedge a long put, an investor may purchase a call with the same strike price and expiration date, thereby creating a long straddle. If the underlying stock price increases above the strike price, the call will experience a gain in value and help offset the loss of the long put.