I been looking at this problem for ages but I swear it must be an error. The question states:
Suppose the delta of a put is -0.6. You own 10 shares. How will you hedge the portfolio?
A. Long 16 calls
B. Short 16 puts
C. Long 16 puts
D. None of the above
The answer says its B. But surely its C?
My rationale is that to hedge a long position in a share you would need to purchase a put. Further, because their are 10 shares in the portfolio and the hedge ratio is -0.6 you would need 16 put options to hedge this risk. Is this correct? Or am I wrong?
As a general rule, you cannot hedge with a short position in options. To hedge, you need to be in control; in a short position, you give control to the party to whom you sell the options.
You’re correct: B cannot possibly be the right answer. It’s C.
The problem with using short calls for a delta hedge is that you risk having your underlying stock position called; the idea of a hedge is to reduce your risk, not to increase it.
Using a short position in options for a delta hedge is . . . unwise.