Straddle Reverse Knock Out
As with vanilla options, it is possible to carry out hedging strategies with exotic options. Here we will set up a Straddle Reverse Knock-Out (RKO) to illustrate the possibility of combining several exotic options in order to achieve less expensive hedging than with simple vanilla options. An RKO straddle therefore requires a call and a put with the same strike price and maturity, as well as deactivating upward barriers for the call and downward barriers for the put. For example, let’s imagine that an investor wants to make a RKO straddle with the FTSE 100 as the underlying asset. The investor will be long a call with a strike price of 6500, a barrier at 6800 and a 3-months maturity, and a put with a strike price of 6500, a barrier at 6200 and a 3-months maturity. In this case, the investor will bet on very low volatility of the underlying asset, which is why the barriers are located close to the strike price, which is the current price of the underlying. For a classic straddle, the delta of the call would be equal to 50 and that of the put would be equal to -50. In an RKO straddle, the call delta is equal to 40. If the price of the underlying increases by, for example, 100 points, i.e., 6,600 points, the delta would be 28. If the spot rises further to 6700 points, the call delta would be about 14. We can see that the delta of the Call decreases despite the increase in the price of the underlying. This is because the underlying is approaching its deactivating barrier. It will even become negative if the price of the FTSE 100 continues to rise. It is when the sign of the delta reverses that the premium hedge policy is put in place. It is carried out with the help of a simple equation:
Here, the barrier is at 6800 and the spot is at 6700 points. We will therefore find a delta equal to -67 by solving the above equation. For the investor, this means having to buy 67 contracts on the FTSE 100 at 6700 points in order to remain delta neutral. We note that the payoffs stop once the barrier Level has been breached, which also explains the change in sign of the delta when the price of the underlying approaches the barrier Level, hence the need to hedge the premium.
Written on 14/12/2020