Using the above example for DBS. To hedge, the formula to apply is:
(Vol.DBS)x(DBS SharePrice)x(%change DBS SharePrice) + (Vol.DLCx5shortDBS)x(DLC price)x(%change DLC Price) = 0
The intention is simple. The main idea is that losses in DBS share price are to be offset by gains in the DLC short position. The reverse is also true.
Because %change in DLC price is negative 5 times the %change in underlying, with some shifting of terms in the equation using 1000 shares of DBS at $25.20 price,
$25200 = (Vol.DLCx5shortDBS)x($0.565)x5
Solving for Volume of DLCx5shortDBS required will be 8920.354 rounded to 3 decimal places. And if you multiply 8920.354 with $0.565, that equals $5040.
Hold on a second. Isn’t $5040 simply $25200 divided by 5?
Well that is a simple beauty right? It makes mental calculations so much easier in a way. Breaks it down to 3 steps:
- What is the size of the position you want to hedge? ($25200)
- Divide it by the leverage factor and
- Divide the answer by the DLC price to arrive at the volume required.
Hold your horses. Nothing is perfect in this world.
- Brokerage and clearing fees apply.
- Com’on the calculations above are based on brokerage free assumptions
- Hedge is not for long term.
- DLC performance is subject to sequence of returns changes therefore the longer term holding the lower the effectiveness of the hedge.
- Hedging is not perfect. Either you purchase 8900 or 9000 units of the DLC.
Snippet from https://dlc.socgen.com/en/education/handbook
DLCs are not just used for hedging of course, people do use it for speculation as well. A knife has great utility, it can be used for chopping vegetables or it can be used to stab someone. DLCs belong to the derivatives asset class . To hedge or not, to speculate or not, it’s all about the view right? What is yours?
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