Say you’re holding lots of Treasury bonds and you want to hedge them with options on Treasury bonds. What’s the best way to do it? I suppose it’s rather like being long stock and deciding to go with a protective put or a covered call, but I guess I’m also of the opinion that protective put makes more sense than covered call, if your objective is to hedge. Of course, if the client in the question is interested in earning some income from writing calls, then I wish the test prep provider who wrote the question might make that clear. For the curious, these thoughts are inspired by 18.1 in Schweser’s 2nd afternoon exam, book 6.
if you want to hedge them you can but put options on the bonds or sell futures against the bonds.
bigwilly Wrote: ------------------------------------------------------- > if you want to hedge them you can but put options > on the bonds or sell futures against the bonds. Understood. Those are the tactics I would choose myself. But if you wanted to “hedge” your position, why would you sell calls? Obviously, I got the mentioned problem wrong because I thought the chosen hedging strategy was stupid, and paid no attention to the delta stuff.
I never said sell calls…but you COULD sell calls to earn the premium. If you sell the calls you limit your upside, and then if you use those proceeds to buy a put you limit your downside, which is called a Collar.
I know you didn’t say to sell calls. That was the strategy chosen by the client in the mentioned question, though. I thought it was a stupid strategy and that was part of the reason I missed the question. Anyway…
If I remember the question, isn’t that the one where they’re using a delta hedge? In that case you would sell calls to hedge a long position. (positive call delta --> sell 1/delta calls to hedge long position) I remember the question b/c I’ve only encountered delta hedging with equities, but I guess it would apply to tsy’s as well?
Well if the context of dynamic hedging you can sell sufficient number of calls (of course limiting your upside) that will provide a sufficient cushion to absorb losses on the declining position. If your position will expirience a sudden drop in big proportion, this covered calls strategy won’t be much effective, that’s why bying puts is much more natural way to hedge, since after you have the put, you don’t care by hom much the position will drop since you have insurance against it. But you also got to keep in mind that buying puts costs money, and selling covered calls brings you money instead. So the tradeoff, would you want greater safety and willing to pay for it up front vs. have less safety, don’t pay anything for it, but limit your upside.