This is on barrier shift for a down and in put option. A down and in put option at 100%/70%(that is strike -100% and knock in -70%), then priced as barrier level-with 67% This is becoz around barrier level, absolute delta would be greater than 1 and then clsoe to 1, once options are in the money. Delta hedging would lead to excess short positions, that would need to be unwound once barrier level is breached, possibly at a loss The question is by pricing at as 67%- would trader gradually unwind positions to make it delta hedged-meaning that the position would become delta hedged once the price is 67, instead of 70, when the delta changes. Or does barrier shift-involve something else? Could someone please clarify?
Generally, it just means that the option is modeled and hedged as if the barrier is 67%, not 70%. So, the delta near the barrier is artificial and generally understated in magnitude. It is not feasible to construct a perfect hedge for barrier options near the barrier (since delta is so high). The method that you described is a way that trader’s “cheat” in their hedging.
Tks. A quick clarif. The huge delta shift occurs when the price is close to 70% (the option is about to knock in). But at 67% of the original price, the delta should be very high (close to -1) as the option is knocked in. Now if the trader were to delta hedge at 67%, the amount of hedging to be done, should be much less than that to be done at 70%. So would be there be any loss to be delta hedged at 67%, as compared to hedging at the original barrier of 70%- becoz the change in delta around the barrier is only temporary.
Read up on pin risk and ‘infinite gamma’