Reading 49 EOC Question Help

[afilippi]

“The best strategy to hedge your shares in Apoth would be to buy 6-month European put options to protect from a loss if the FDA rejects Apoth’s new pharmaceutical.”
Exhibit 2. Market Data for 6-month European Options on Apoth Shares

Option

X


Type of Option

Call


Exercise Price

$46.00


N(d1)

0.30


N(d2)

0.21



Using the data from Exhibit 2, the number of option X contracts that Klein would have to sell to implement the hedge strategy would be closest to:
Could someone help me with this problem or perhaps point me to what page they talk about it in the reading? If we are long on the shares and are trying to hedge against a fall in share price, shouldn’t we be buying and not selling call options?

 

[oz001]

If you are long shares you need to SELL call options because a short call position gains when shares fall, thus providing the hedge.
For such hedging questions it may help to think in terms of delta. The delta of a long stock position (1 share) = 1. A delta hedged position has delta = 0. Therefore in order to hedge the stock position you would need to add negative delta to your portfolio. The negative delta could be provided by a long put or a short call.
For an option (according to BSM model), N(d1) = delta. If N(d1) = 0.30, your call has delta 0.30. To obtain a delta = -1, you need to short (sell) 3.33 call options for each long stock.

 

[S2000magician]

oz001 wrote:If you are long shares you need to SELL call options … .

With all due respect, you cannot hedge a position by selling options: you’re putting your fate in someone else’s hands.
To hedge a position using options, you have to buy the options, so your fate is in your hands.
If you have a long position in the underlying, you hedge it by buying puts, not by selling calls.

 

[oz001]

The question asks how many call options should be sold to implement the hedge strategy. In my view, whether a long put is a better hedge strategy is beyond the scope of this question (the header states that the best strategy is to buy put options).

 

[S2000magician]

Perhaps an e-mail to CFA Institute is in order; selling call options is not a hedging strategy.