ABSTRACT
Hedging a cash position with a long option protects the hedger against unfavorable price changes, but allows them to benefit from favorable price changes. While this might appear to be the best of both worlds, the cost of the premium may be so large that it outweighs any potential benefit that might occur from a favorable price change. In addition, we discovered in Chapter 14 that the delta is not constant over the life of an option, so the number of options required to hedge a particular cash position will change over the duration of the hedge. Consequently, a hedge using a long option must be managed more carefully and actively than a futures hedge, all else the same. Notice that the basis issues described for futures hedges in Chapter 7 apply equally to option hedges, but for simplicity they will be ignored here. Also notice that the examples in this chapter will ignore commissions and other transaction costs, as well as time-value-of-money adjustments to correct for differences in the timing of cash flows.
