Chartered Financial Analyst (CFA) Practice Exam Level 2

In delta hedging, how are options needed calculated?

1. Options Needed = (Delta of Call or Put) / (# SHS)

2. Options Needed = (Delta of Call or Put) * (# SHS)

3. Options Needed = (# SHS) * (Delta of Call or Put)

4. Options Needed = (# SHS) / (Delta of Call or Put)

The correct answer is: Options Needed = (# SHS) / (Delta of Call or Put)

In delta hedging, the goal is to eliminate the risk associated with price movements in the underlying asset by using options. The delta of an option represents the sensitivity of the option's price to changes in the price of the underlying asset. It is a key component in calculating how many options are needed to hedge a particular position in stocks. To achieve a delta-neutral position, the equation involves adjusting for the number of shares held in the underlying asset relative to the delta of the option. The correct calculation for the number of options needed is based on the relationship between the number of shares and the delta of the option. Specifically, because delta reflects how much the price of the option is expected to change with a unit change in the price of the underlying asset, the formula involves dividing the total shares held by the delta of the option. This way, you determine how many options you would need to offset the risk of holding those shares. A higher delta means that fewer options are required to hedge a larger number of shares because each option responds more strongly to movements in the underlying asset's price. Conversely, a lower delta means more options are needed to counterbalance the risk from the same number of shares. Thus, the proper formulation for calculating the number of options