On Schweser Notes Book 5 P. 259 there is this formula for calculating number of options needed to delta hedge, followed by another equation: hedge ratio=1/delta which is confusing for me, isn’t hege ratio=delta??? Then on P. 270 concept checker question 2, they say hedge ratio is equivalent to delta, but I was applying “hedge ratio=1/delta” to the question. Am I missing something here? Could someone help me get around this please?
Please shed some light!
Hedge Ratio = (C+ - C-)/(S+ - S-) = Delta (formula given on pg 239) Above formula can be put as Hedge Ratio = Delta, this hedge ratio is used to find the number of fractional shares to hedge a given number of options. For example if you have 1000 options then to find out how many fractional shares need to be shorted you can get by the formula 1000*Hedge Ratio. On page 259, Hedge Ratio = 1/Delta, this is because we want to find the number of options we need to short to hedge a given number of shares. For example if we have 1000 shares and we want to create a delta neutral portfolio then we can do this by 1000/Delta or 1000*hedge ratio. Basically hedge ratio is a multiplier which would give us the number of option or stocks needed to create a delta neutral portfolio. To avoid confusion I try to remember that delta for a stock = 1 and the portfolio of stocks and options should have delta sum = 0 (for a delta neutral portfolio).
Many thanks for the explanation! Really appreciated.
Good stuff thanks.