Q on hedging strategy

[Saturdaynitefeva]

This is a question from Book 6:
An investor is short a portfolio of stocks that has volatility and return characteristics similar to that of the S&P500. Which of the following strategies would best hedge the market risk of the short portfolio position?

A. Buy at put option on the S&P500

B. Write a call option on the S&P500

C. Take a short position in the S&P500 future contract

D. Write a put option and buy a call option on the S&P500


Answer is D:
The word �hedge� means to reduce risk. Since the investor is short the portfolio, he will have gains as stock prices fall and will have losses as stock prices rise. Hence, hedging requires a position that provides gains as prices rise and losses as prices fall. If the investor buys, calls, and writes puts in the correct proportions, he will have offset the market risk of his short portfolio.

While I understand that you will want to hedge your losses, why enter into a position that offsets your gains?

 

[bannisja]

to mitigate your risk

why do people write covered calls if it limits their upside on a stock?
they're willing to trade off points on the upside for some income and protection on the downside.

why do people buy protective puts instead of just selling the stock outright if they think it's going down? maybe you think the stock is a nice long term play but in the short term it might take a dip. maybe it has earnings coming up and you've done well in the name and would like to stay long it but don't want to get burned if the earnings are awful and the stock tanks, so you pay a little premium and buy the put just in case.

anytime you hedge, you're trying to reduce your risk. offsetting your gains, hedging your losses, tomato, tomato, you're reducing your risk.

 

[Saturdaynitefeva]

hmmmm still not sure....the PM in the example is short so he wants the stock prices to go down. Not good for him if they go up so he hedges that scenario - so far so good but why does he hedge against prices going down? Maybe my brain is blocked, sorry....

 

[mwvt9]

That is the whole idea.

He has made a bet on prices going down...if he is now worried about that bet, he takes an offsetting position to immunize the risk that he is wrong on the "prices going down" bet. He hedges his original bet.

Hope this helps.

 

[planner]

The question is, "Which of the following strategies would best hedge the market risk of the short portfolio position?"

The answer given is, "Write a put option and buy a call option on the S&P500 ."

If the opposite question is posed, "Which of the following strategies would best hedge the market risk of a LONG portfolio position?" Wouldn't the answer be to write a call in order to fund the purchase of a put? SO...you're limiting your upside but protecting the downside. So, wouldn't writing a put and buying a call hedge him with a SHORT position?

The purpose of selling the put is not to hedge the position but to fund the purchase of the call.

Someone correct me if I've missed something.

 

[JoeyDVivre]

How about this? A perfectly hedged position returns the risk-free rate no matter what the market does.

 

[veerasam]

Planner - I agree - writing a call can fund the put. If the strike prices are set up correctly, the hedger can take a window of risk, but protects himself for price movements outside the window.

 

[plyon]

Saturdaynitefeva Wrote:
-------------------------------------------------------
> hmmmm still not sure....the PM in the example is
> short so he wants the stock prices to go down. Not
> good for him if they go up so he hedges that
> scenario - so far so good but why does he hedge
> against prices going down? Maybe my brain is
> blocked, sorry....

Saturday... I think your block is based on your interpretation that "the trader is short so he wants...prices to go down".

THAT'S NOT IN THE QUESTION. You are assuming something that you shouldn't be. All we know is that the trader IS short (not that she WANTS to be short). There are any number of reasons that one could end up being short an asset even if you would rather not be.

Once you've seen through that part, you should be able to see the answer more clearly.

 

[Saturdaynitefeva]

Tks for all your answers - Plyon you're right, guess I was focusing too much about what I would want prices to do when I am short! Happy studying....