Situations where an options hedge raises risk
Question
When can hedging an options position actually leave you with more risk rather than less?
Short answer
When the hedge does not move with the exposure, or it creates new risks. Examples: hedging with an instrument that is poorly correlated with the true exposure (basis risk); using a wrong model or volatility, so the computed delta is wrong; price jumps that a delta hedge cannot follow; cash-flow and margin calls on the hedge leg before the option pays off (Metallgesellschaft); and hedging one leg of a book whose other positions already offset it, which turns a flat position into a net one.
Adapted from Crack, Heard on the Street, Q2.42, p.30; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- The Law of One Price and Replication: No-Arbitrage Pricing from First Principles
- The One-Period Binomial Model: Replication, Delta Hedging, and Risk-Neutral Pricing
- Derivation — From Binomial Trees to Black-Scholes in the Continuous Limit
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