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1. popa_bar_abba
   Incorrigible; eccentric; somewhere between mean and average; sometimes only a bit over the top; arbitrarily engaged in cynicism.

   Anyone who can explain this to me adequately, will be awarded with a dedicated troll thread.

   The black scholes theory is based on the notion that you can completely hedge an asset by selling a certain number of calls and buying a certain amount of debt. And then you adjust the amount every time anything shifts.

   I don't get that. It seems obvious that if the stock completely failed overnight, that you'd be in a loss position. So it only works for small shifts. Well, how could it work for small shifts but not for big shifts? Does that mean you are taking small losses and gains the whole time?

   Someone said to me because it needs to pass through the small changes to get to the big changes. I don't see how that would make a difference.

   Anyone know anything?

   Posted 3 years ago #

2. squeak
   Makes smalltalk with the two most sandy ectoplasmic beings on Earth (not to mention the Man on the Moon).

   You have it a bit wrong, the theory is about hedging an option by buying and selling an asset.

   Posted 3 years ago #

3. squeak
   Makes smalltalk with the two most sandy ectoplasmic beings on Earth (not to mention the Man on the Moon).

   I've waited for your reply, but it's getting late. Here's my best guess at what will help you, and next time I check in I can see what you were really looking for.

   To make it simple, suppose you bought a call option at the money. If the underlying asset goes up you will get the asset for below market cost, and if it goes down you do nothing. The same thing is achieved by buying the underlying and a put option at the money - if the asset goes up you have the appreciated asset, and if it goes down you sell it for the strike price.

   The only difference is the time value of money- you need to borrow money to buy the call in the example, and you need to borrow money in the counter example equal to the price of the asset and the put. That is the debt/bond piece.

   If the stock failed overnight you'd lose nothing - if you have a call option nothing at all happens, and if you have the stock plus a put option you can force it on someone else for the strike. You can google put call parity theory if you want to understand the math behind this.

   Black Scholes uses this concept, and comes up with the price for the options. Nothing more or less. I don't think you've made it clear what your question is, or what it has to do with BSM, but go ahead and rephrase.

   Posted 3 years ago #

4. popa_bar_abba
   Incorrigible; eccentric; somewhere between mean and average; sometimes only a bit over the top; arbitrarily engaged in cynicism.

   Ok, that much I understand. If you have a long, and buy a put at the money, then you are completely hedged against loss--minus the money you paid for the put. And you still have the gain potential.

   My question is about calls and puts which are out of the money. Apparently it is believed (and this is the theoretical basis for black scholes), that you can always completely hedge an asset by selling calls even if they are way out of the money if you buy enough of them.

   So that, perhaps you will need to by 18.64 calls, and also some debt, and then you will be completely hedged against your one share of stock. And that you will then adjust your hedge as more information comes out. This is what I don't get.

   (Then, they took this idea, and said that you can therefore figure out the correct price of the option, by figuring out how many options you'd need to sell, and then solving for x.)

   And I didn't respond before, because I thought you were kidding, because it seemed like you just wrote the same thing again from the other angle.

   Posted 3 years ago #

5. squeak
   Makes smalltalk with the two most sandy ectoplasmic beings on Earth (not to mention the Man on the Moon).

   because it seemed like you just wrote the same thing again from the other angle.

   No, what we wrote was very different. You said "hedge an asset by selling a certain number of calls and buying a certain amount of debt" and I said, "hedging an option by buying and selling an asset". Either you are a few steps further down the road and therefore ignoring the basics, or you missed the most basic concept.

   First of all, selling calls on the underlying asset doesn't hedge anything- it justs limits your upside. (Though if you think of it in reverse, i.e. you have sold an uncovered call, buying the underlying asset is is a hedge.) Second, I don't see how that has anything to do with BSM, which sets prices for derivatives, nothing else.

   If you want to talk about dynamic hedging strategies, fine. Just make your question clearer is all I ask :)

   Posted 3 years ago #

6. squeak
   Makes smalltalk with the two most sandy ectoplasmic beings on Earth (not to mention the Man on the Moon).

   Also, leave debt out of the discussion because that is only to take care of time value of money. Assume a 0% interest rate.

   Posted 3 years ago #

7. popa_bar_abba
   Incorrigible; eccentric; somewhere between mean and average; sometimes only a bit over the top; arbitrarily engaged in cynicism.

   I want to talk about dynamic hedging. The paper I was reading was completely basing itself on the black scholes theory, so I cited it. I donno much about this, so I figured that would make people understand what I was talking about.

   I was reading 57 Tax L. Rev. 397. And didn't understand so much as a word.

   Posted 3 years ago #

8. squeak
   Makes smalltalk with the two most sandy ectoplasmic beings on Earth (not to mention the Man on the Moon).

   OK so you want to talk about tax treatment of hedging strategies. IANAL, nor a tax expert of any kind so I will have to bow out as soon as it goes there. I would suggest that if you just want to learn about taxation you don't need to understand too much about how dynamic hedging works, and certainly not the mathematics behind the pricing of the derivatives!

   Dynamic hedging is a very expensive way to hedge risk by trying to keep your hedge up to date. Suppose you buy an asset and a put option at the money. You are now hedged against loss. If you keep that until maturity and then sell the asset you have a static hedge. But suppose when the asset price goes up or down you want to lock in your profits/unlock the value of your hedge - you can sell the put and get a new one at the money. That is an example of a dynamic hedge- always updating the hedge to the most recent market information.

   Obviously, in real life a dynamic hedging program won't be implemented for a silly reason like the example I gave. But what else do you need to know? Assume the people running the program have a good reason for the transactions they make. Essentially, the buys and sells in a dynamic hedging program are not individual transactions but pieces of one large transaction. I don't think it gets treated that way, though, for taxes.

   Posted 3 years ago #

9. popa_bar_abba
   Incorrigible; eccentric; somewhere between mean and average; sometimes only a bit over the top; arbitrarily engaged in cynicism.

   Just read the article and tell me how it works, ok?

   Posted 3 years ago #

10. squeak
    Makes smalltalk with the two most sandy ectoplasmic beings on Earth (not to mention the Man on the Moon).

    no se hava lexis

    Posted 3 years ago #

11. popa_bar_abba
    Incorrigible; eccentric; somewhere between mean and average; sometimes only a bit over the top; arbitrarily engaged in cynicism.

    can you get it at the library?

    Posted 3 years ago #

12. squeak
    Makes smalltalk with the two most sandy ectoplasmic beings on Earth (not to mention the Man on the Moon).

    Sure. No rush, then? You could also summarize it and articulate your questions :)

    Posted 3 years ago #

13. popa_bar_abba
    Incorrigible; eccentric; somewhere between mean and average; sometimes only a bit over the top; arbitrarily engaged in cynicism.

    I can't summarize it, because I don't understand it

    Posted 3 years ago #

14. squeak
    Makes smalltalk with the two most sandy ectoplasmic beings on Earth (not to mention the Man on the Moon).

    popa, zein mir moichel. I have not had a chance to get the article and I can't promise I will soon. So I hope you got someone else to discuss it with, or that you can hang in there indefinitely. Or copy/paste the whole article here, hehe. But it would be good for me not to feel like I owe you a response.

    Posted 3 years ago #

15. popa_bar_abba
    Incorrigible; eccentric; somewhere between mean and average; sometimes only a bit over the top; arbitrarily engaged in cynicism.

    I spoke to someone. Thanks.

    Posted 3 years ago #

16. popa_bar_abba
    Incorrigible; eccentric; somewhere between mean and average; sometimes only a bit over the top; arbitrarily engaged in cynicism.

    I met a frum guy who is a professor at harvard, and he explained it to me.

    Posted 3 years ago #

17. squeak
    Makes smalltalk with the two most sandy ectoplasmic beings on Earth (not to mention the Man on the Moon).

    Noah Feldman? So why did you bother asking me in the first place?
    BTW, he called me to get help understanding the mechanics before he responded to you.

    Posted 3 years ago #

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