Reading 62, page 234, qestion 8. the question ask how much call option to buy to hedge a drop in the stock price? so weired. it should buy put to hedge the drop of the stock price, isn’t it? sell call option when price drop , the only gain is the premium collected, it is not a hedge strategy really… Thanks.
Your post is very confusing. Initially you state buying calls. You later correctly specify selling calls (which is indeed what the question asks). Given that you are selling calls, it is a simple question - about dynamic hedging using options. Call = positively correlated with stock. You are long stock, you short calls. That is hedging.
…right, but it isn’t a perfect hedge, which you would get by buying a put.
Yeah right. If the asset does not move, assuming that the put you purchased was at the money, it would result in a sure loss (of the premium on put). What kind of hedge would that be??? Dreary Wrote: ------------------------------------------------------- > …right, but it isn’t a perfect hedge, which you > would get by buying a put.
Perfect hedge does not mean costless. It means hedging with a relatively small and known maximum loss beforehand…compare that with selling calls, especially with transaction cost.
i wrote a question about this earlier. it’s a stupidly worded question but the reason why the answer makes sense is because the question specifically says “which option would you SELL”. ok. well you wouldn’t sell a put to hedge a long stock position, because if the stock drops you have the stock put to you and you end up buying more. so the only option is to sell calls. selling calls is a legitimate way to hedge a long bet on a stock. it’s called covered calls or writing covered calls. you basically get premium if the stock doesn’t reach the strike price. if the stock rises you get the option premium and still the value of the stock up to the strike price (assuming it gets called away from you). so if you strike at $45 and sell calls for $3, your exit price maximum is $48. Stock goes to $52 and you left money on the table, stock goes nowhere and you pocket the $3. i got this question wrong too, because the most sensible way to hedge your bet is to buy puts based on what the scenario explained. but again, the question specifically said, “which option would you SELL” which I didnt read carefully enough. you can search the archives to read my bitter anti-CFAI response to the purpose of this question (ie. test reading comprehension vs. testing actual financial knowledge)
If there are no transaction costs and plenty of liquidity, and minimal spreads, then dynamic hedging by selling calls works like a charm. You buy a stock for $40, and immediately sell the $40 calls, collecting some premium. If it drops again, you sell more calls, collecting some premium again. As it continues to drop to zero, you would have collected enough premium to hedge your entire position. In the real world, no way.