1009300-Cor-6 - Equity Derivatives and Related Products...

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Unformatted text preview: Equity Derivatives and Related Products Class 6: Practical Considerations in Using Options / Structured Notes Mark Zurack October 5, 2010 1002011-MBA-5 2 Class Objectives Review how Delta Hedging creates profits and losses for traders Show the class how to use an Options Calculator, emphasizing the shortfall and financing cost of hedging the options To explain why transactions costs and interest rates are important to options pricing and what interest rate is relevant for a particular transaction To show the range of S&P 500 realized volatility of the past 75 years To show the relationship between implied and historical volatility and explain why it exists To explain how the implied volatility of an option is related to its strike price (skew) and time to expiration (term structure) To discuss what Structured Notes are, how they are created and used by investors 1009300-Cor-6 1002011-MBA-5 3 How Options Traders Make (or Lose) Money Most option traders do not take directional views (i.e., bullish or bearish) when creating or hedging options positions. Instead, they utilize an option model to create an offsetting hedge to neutralize the underlying price risk of the option. This hedge can be executed with the underlying stock (or index) Since the amount of stock required by the hedge changes as the stock price changes, the process of replicating an option is often referred to as dynamic hedging or delta hedging. It requires making the following adjustments over time: The Delta Hedging Process Option traders neutralize their exposure when making a market by buying or selling the underlying stock Initial Position Delta Hedging Stock Up Stock Down Buy Call Sell Call Buy Put Sell Put Sell Stock Buy Stock Buy Stock Sell Stock Sell More Stock Buy More Stock Sell Stock Buy Stock Buy Stock Sell Stock Buy More Stock Sell More Stock 1009300-Cor-6 1002011-MBA-5 4 Dynamic Creation (Hedging) of Option Payoff Call Value Underlying Price 0.25 Delta 0.50 Delta Forward Price 0.75 Delta To replicate option payoffs, option traders hold an offsetting delta position in stock or futures, shifting their holdings as the underlying price moves Gamma equals the change in delta for a $1 change in the price of the stock 1009300-Cor-6 1002011-MBA-5 5 Delta Hedging Example ABC is a technology company which is currently trading at $100. 3-month, at-the-money call options are trading at $5. The calls have a delta of approximately .5 I am a dealer considering either selling or buying one call option. How do I initially hedge the option?...
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This note was uploaded on 01/25/2011 for the course NBA 6940 at Cornell University (Engineering School).

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1009300-Cor-6 - Equity Derivatives and Related Products...

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