Risk Mitigation Strategy Based on Price Deviations From Strike Price

Abstract

An option writer often faces unlimited liability and high risk especially when the spot price moves up away from the strike price. He can hedge the risks and the unlimited liability, using delta hedging with rebalancing the position on a daily basis. When there is no liquidity in the market for the options at the specific strike price, the option writers would not be able to square off their positions and even dynamic delta hedging would not help in minimizing the losses that the option writer would incur. This paper discusses the timing that the option writer could observe to implement the recovery strategy so that he could offset the unlimited risk that he faces in order to minimize his losses. For the purpose of the study, only the call option contracts limited to the near month have been considered (volumes and liquidity for the mid month and far month is very low). The study also examines the changes in volume at different strike prices as the contract moves closer to maturity and the percentage deviation in spread corresponding to the drop in volumes. Recommendations based on the findings are made and limitations of the study and future scope identified.