If a trader has a short position in put options and wants to hedge his exposure using equity contracts, what trade should he ideally do? Shall he go long or short on equity contracts?
I thought in order to hedge he should short the equity contracts but the answer is he has to go long. Can anyone explain it?
Thanks a lot.
He created a short position using puts…thus to hedge he should long the equity.
I believe that you are interpreting that he sold puts.
I am sorry for the wrong wording. He in fact has actually sold put options on certain number of shares of underlying equity. Hence, my doubt.
Selling puts --> long position to the underlying
To hedge, he must go short, thus he should short equity
Unless theres something else in the scenario, the answer that “he has to go long” is incorrect
Here is my opinion:
Facts:
Trader shorted put option.
Put option has negative delta.
To maintain delta hedge in general he should:
option delta times (Original number of shares) and put has negative delta
- - delta (Number of shares) thus + delta (Number of shares).
In case he bought put option instead shorting, he would go
- delta (Number of shares), thus he would sell shares to maintain delta hedge at long put.
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You are right.
I’m still thinking about this but i think it is not the correct way to hedge. The strategy is like a reversed-protective put.
When stock price rises, the maximum loss of the overall strategy (i.e. sell put + sell stock) is unlimited (and therefore not hedged) due to stock price hypothetical ability to increase to infinity, because the income from selling the put is limited. Draw the reversed-protective put in a graph (reversed across the x-axis) and u’ll see…
The question then goes ahead and calculates the number of shares he should buy and calculates it as -No * delta = Ns, where No is the number of put options he initially sold and delta is a negative number (for put options). So, Ns comes out as a positive number, which represents the number of shares he should buy in order to hedge.
I am confused here since the trader has sold the put options and not bought it. I agree with both Flashback and Kevin’s thought process but just want to make sure that the answer is incorrect.
That’s fine. But if we hedge it by going long the stock, overall strategy being [sell put + buy stock], then what about the case when stock price falls a lot? He will loose out on both put as well as stock. Are you trying to say that in this case ideally, the maximum loss is floored in case when stock price plummets to zero contrary to the other strategy which you mentioned in case max potential loss is infinite. I think it does make a bit sense now thinking on this track.
Lets take the strategy: Buy stock + Sell put
If stock price reaches infinity, maximum profit = Infinity
If stock price reaches zero, maximum loss = Stock price + Exercise price - Premium —> this is not actually hedged, is it?
Therefore buying stock cannot hedge the initial position. Meaning the answer is incorrect. You cannot hedge a short position in put by buying/selling stock…
Perhaps S2000magician can enlighten us on this…
I will report back after additional studying this query. However, thanks for this question, it’s useful as well as read all responses and opinions.
And if we take the other strategy of trader: Short stock + Sell put
Max Loss for trader = Infinite (When stock keeps going up, put expires worthless)
Max Profit for trader = S + Premium - X (When stock price goes down to 0, put exercised at X)
In this case max loss is potentially infinite (I believe can’t be a good hedging strategy where you are locking in a maximum loss of infinity), whereas in the one you mentioned, max gain is infinite and max loss is floored. Shouldn’t that be a better hedging strategy (you are locking in a maximum loss floored at a particular level)? (i.e Long stock + Sell put)
Sure. Thanks for your responses. They are always useful.
It is floored because stock price cannot drop into negative territory, thus it is a “flawed” hedge like covered call
Yea/no. I’m stuck as u are…
And i thought i mastered the art of option derivatives… lol
Still I believe you have come quite far in understanding the concepts! Should be enough to sail you through but its always good to have a conceptual clarity around all these concepts. They seem pretty easy at the beginning but once we deep dive, it can get challenging.
I think S2000 magician can give the best conclusion to this thread. I am sure we don’t need to do so much analysis just to decide the hedging strategy!
Short the stock.
In summary of the above:
Initial position: Sold put options
Million dollar question: how to hedge the exposure if stock price of underlying falls?
Answer 1 (sell stock)
New position: Sell put options + Sell stock [This strategy is a reversed-protective put]
Loss of strategy can in theory be unlimited as stock price reaches infinity, therefore this does not look hedged to me, eh?
Answer 2 (buy stock)
New position: Buy stock + Sell put options
Loss of strategy can in theory be significantly large but not unlimited as stock price reaches 0, there this does not constitute a good hedge to me, eh?
To S2000magician: therefore we cannot simply short the blessed stock, can we? Actually we cannot hedge the initial position by either buying or selling the stock.
If we think that the stock price will decline, we can hedge against that.
We weren’t given a choice of other securities to use, only equity futures. Given that restriction, the only thing we can do that makes any sense is to take the short position.
I agree, we’ve essentially traded one potential loss for another.
If you want to hedge the risk 100% there’s essentially only one thing you can do. I’ll leave that to your imagination, but I will tell you that it isn’t particularly interesting. At all.