How does shorting (with a derivative instrument) an underlying long position make your position effectively risk-free?
I would think the position goes neither upside nor downside… which would effectively lock-in the price movement at 0.
(this keeps bugging me, because this is one of the main reasons why i don’t fully understand how delta-hedging works, either…)
please help.
risk free = 0 risk … gain on underlying = loss on derivatives or vice versa.
He may be using the term “risk-free” in the sense of “earning the risk-free rate”.
If you enter into the short position in a forward contract, the price will be today’s price increased by the risk-free rate; that was covered at Level I (and Level II).
This has always been a bit nebulous. Basically they assume you ‘invest the short proceeds’ at the risk free rate. You don’t just sit on it and earn nothing.
It’s a bit more complicated when you’re selling short (which is why I only mentioned a forward contract, above): you have to borrow the securities you’re selling, and pay rent on them while you’re borrowing them. That rent will lower your return on the short sale proceeds. However, because you’re also long the same securities, you could lend them to another short seller and charge the same rent, negating that and returning you to the risk-free rate.
As I said: more complicated.