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These classes are all based on the book Trading and Pricing Financial Derivatives, available on Amazon at this link.

Hello youtube welcome to today’s video where we’re going to learn about dynamic hedging of options this is possibly the most important thing you can learn about options and once you understand this everything we’ve learned so far will start to make an awful lot more sense stay tuned to the end of this video where i will tell you how to win a free copy of my newest

Book trading and pricing financial derivatives there’s a link to it in the description below dynamic hedging is an approach used by options traders to hedge their options positions because this approach involves adjusting the hedge as the underlying asset moves it’s referred to as dynamic hedging while dynamic hedging is important to understand as a hedging technique

It is more important to understand it because of the link between this hedging technique and options pricing theory once you understand how dynamic hedging works you can understand how the various options pricing techniques work and understand why option traders think about options as volatility bets rather than bets on the future price of an underlying security

A replicating portfolio for a given acid or series of cash flows is a portfolio of assets designed to replicate the cash flows or market values of another asset in all market scenarios the idea is that if you can find a replicating portfolio for a given asset this portfolio must then be priced the same as the asset it replicates otherwise an arbitrage opportunity

Would exist if there is a replicating portfolio for an option made up of the underlying stock under bond for example we can then use the prices of those instruments to work out the fair value of our option if the replicating portfolio requires constant adjustment which we call dynamic hedging then the price of the option should relate to the cost of creating this

Dynamic portfolio replicating portfolios can occur in two ways static replication where the portfolio has the same cash flow as the asset in question and no changes to the portfolio need to be made to maintain this and dynamic replication where the standalone portfolio does not necessarily have the same cash flows as the acid it seeks to replicate but once the

Trading strategy underlying the replication is followed the cash flows of the portfolio matched the cash flows of the underlying asset perfectly dynamic replication requires continual adjustment as the asset and portfolio are only assumed to behave similarly for small market movements the notion of a replicating portfolio is fundamental to options pricing which

Assumes that market prices are arbitrage free as our patrasche opportunities are exploited by constructing replicating portfolios and trading one against the other to profit from price discrepancies one of the most important things to understand about call and put options and their pricing is that their payoffs can be replicated by following a trading strategy in

The underlying without entering into an options position at all this trading strategy which we touched on earlier is known as dynamic replication the fact that this can be done validates our methods of option pricing and allows a trader or arbitrage sure to generate an offsetting or hedging set of cash flows precisely linked to an options cash flows by actively

Trading the underlying and to trade the option if they feel the market is not pricing it correctly as mentioned early on options existed long before mathematical methods for pricing them did once the models came along options traded at roughly the same prices as they had always traded out the big difference was that the volume of traded options exploded this is

Not because the options pricing models made options more accessible to the public but because the options pricing models were grounded in the idea that you could price an option in terms of the price of the underlying and you could hedge the risk of having bought or sold an option by trading the underlying against the option options prices did not really change

Very much after the introduction of the pricing formulas because pricing is driven by market supply and demand dynamics all of our pricing methods include an assumed figure in the formula which is sigma or volatility in reality market forces push implied volatility up and down second by second once traders had a formula that showed them how to dynamically replicate

The payoff of an option they were much more willing to buy and sell them as they could hedge out most of the risk so that is it tune in to my next video where we will work through an example of dynamically replicating a call option oh and one more thing i mentioned at the start of the video that i would tell you how to win a free copy of my book trading and pricing

Financial derivatives well here is what you have to do firstly you have to hit the like button on this video and also subscribe to the channel once i get 200 likes i’ll go through the list of subscribers and randomly choose a winner and sent them a free copy of the book if you’re already a subscriber there’s nothing that you need to do other than hit the like button

Best of luck and see you in the next video have a great day bye

Transcribed from video

Dynamic Hedging of Options – Option Trading Strategies By Patrick Boyle