I am pretty sure shweser is wrong, but I need verification. They are saying that in order to maintain a neutral hedge against a falling equity price, I would buy additional put options as the options delta moves farther from zero. I think it is opposite. As the delta moves farther from zero, the put options become more valuable and therefore less are necessary to maintain neutrlaity. Schweser is saying the opposite is true. Can someone verify or point out the flaw in my logic?? Thanks!
as the delta moves farther from 0, its becoming more in the money. as it becomes more in the money, the gamma increases. as gamma increases, the frequency of rebalancing a delta neutral hedge increases and you need to buy more options. it looks like in your logic you’re assuming that you dont want to maintain neutrality because the put are becoming more valuable. the question says you want to maintain neutrality even though you might end up profiting otherwise.
Don’t mean to contradict, but gamma is at its max when you are at the money (I think, but don’t have book in front of me). As you move further and further away from being at the money, gamma decays as delta approaches -1 or 0. Therefore, as delta moves toward negative one, your hedge ratio would decrease, and you would need fewer options for your hedge.
there is an erratum item on this question in Schweser. Right answer is A). Correction 1AM Q53 You need fewer puts for a delta neutral hedge (not more) as the delta moves away from zero. A should be the correct answer. Posted: 2009-06-01
Awesome. Really appreciate the help. BJ