delta hedge

what determines whether we use call or put options to create a delta hedge? in this Schweser q, i have no idea why they chose put options. ------------- Joel Franklin, CFA, has recently been promoted to junior portfolio manager for a large equity portfolio at Davidson Sherman (DS), a large multinational investment banking firm. The portfolio is subdivided into several smaller portfolios. In general, the portfolios are composed of U.S. based equities, ranging from medium to large-cap stocks. Currently, DS is not involved in any foreign markets. In his new position, he will now be responsible for the development of a new investment strategy that DS wants all of its equity portfolios to implement. The strategy involves overlaying option strategies on its equity portfolios. Recent performance of many of their equity portfolios has been poor relative to their peer group. The upper management at DS views the new option strategies as an opportunity to either add value or reduce risk. Franklin recognizes that the behavior of an option’s value is dependent upon many variables and decides to spend some time closely analyzing this behavior. He took an options strategies class in graduate school a few years ago, and feels that he is fairly knowledgeable about the valuation of options using the Black-Scholes model. Franklin understands that the volatility of the underlying asset returns is one of the most important contributors to option value. Therefore, he would like to know when the volatility has the largest effect on option value. Upper management at DS has also requested that he further explore the concept of a delta neutral portfolio. He must determine how to create a delta neutral portfolio, and how it would be expected to perform under a variety of scenarios. Franklin is also examining the change in the call option’s delta as the underlying equity value changes. He also wants to determine the minimum and maximum bounds on the call option delta. Franklin has been authorized to purchase calls or puts on the equities in the portfolio. He may not, however, establish any uncovered or “naked” option positions. His analysis has resulted in the information shown in Exhibits 1 and 2 for European style options. Exhibit 1 Input for European Options Stock Price (S) 100 Strike Price (X) 100 Interest Rate ® 0.07 Dividend Yield (q) 0 Time to Maturity (years) (t) 1 Volatility (Std. Dev.) (sigma) 0.2 Black-Scholes Put Option Value $4.7809 Exhibit 2 European Option Sensitivities Sensitivity Call Put Delta 0.6736 −0.3264 Gamma 0.0180 0.0180 Theta −3.9797 2.5470 Vega 36.0527 36.0527 Rho 55.8230 −37.4164 Part 4) If the portfolio has 10,000 shares of the underlying stock and he wants to completely hedge the price risk using options, what kind of options should Franklin buy? A) Put options. B) Call and put options. C) Call options. The correct answer was A) Put options. Buying 10,000 put options will allow Franklin to completely hedge the stock price risk.

Because going long the equity and long a call is a straight punt that prices will go up; should they go down, both positions lose money. To hedge yourself with options, you need to create an offsetting position to your equity position, which means that you need something that will increase in value as the price of the underlying equity decreases in value; this is a put.

ok, so the question is asking the hedging of the delta hedge…

pacmandefense Wrote: ------------------------------------------------------- > ok, so the question is asking the hedging of the > delta hedge… Lol, what???

nevermind, i realized the q has nothing to do with the delta hedge, just the hedging of the equity positions.

I think the key is that it asks what kind of options should he BUY. If had said SELL, then it would have been the CALL options rather than the PUT options.