A trader uses a stop-loss strategy to hedge a short position in a three-month call option with a strike price of 0.7000 on an exchange rate.The current exchange rate is 0.6950 and value of the option is 0.1.The trader covers the option when the exchange rate reaches 0.7005 and uncovers (i.e.,assumes a naked position)if the exchange rate falls to 0.6995.Which of the following is NOT true?
A) The exchange rate trading might cost nothing so that the trader gains 0.1 for each option sold
B) The exchange rate trading might cost considerably more than 0.1 for each option sold so that the trader loses money
C) The present value of the gain or loss from the exchange rate trading should be about 0.1 on average for each option sold
D) The hedge works reasonably well

Question

A trader uses a stop-loss strategy to hedge a short position in a three-month call option with a strike price of 0.7000 on an exchange rate.The current exchange rate is 0.6950 and value of the option is 0.1.The trader covers the option when the exchange rate reaches 0.7005 and uncovers (i.e.,assumes a naked position)if the exchange rate falls to 0.6995.Which of the following is NOT true?
A) The exchange rate trading might cost nothing so that the trader gains 0.1 for each option sold
B) The exchange rate trading might cost considerably more than 0.1 for each option sold so that the trader loses money
C) The present value of the gain or loss from the exchange rate trading should be about 0.1 on average for each option sold
D) The hedge works reasonably well

Quizplus · Accepted Answer

A good hedging system will ensure that the cost of selling an option is close to its theoretical value.The stop-loss hedging procedure does not have this property.It can lead to the option costing nothing or costing considerably more than its theoretical value.On average the cost of the option is its Black-Scholes value,but there is a wide variation.D is the correct answer.

A Trader Uses a Stop-Loss Strategy to Hedge a Short