How Traders Hedge and Price Structured Product Options
Summary
The document explains what a trader may do after a client buys a capital-protected product with upside linked to a call option. In a simple case, the trader can offset the option exposure by buying the corresponding market option, with any difference between the client price and hedge cost contributing to the trade’s margin.
When a direct hedge is unavailable or the payoff is difficult to replicate, the trader may manage the exposure dynamically. The example describes estimating an at-the-money call’s delta and adjusting a stock position as the price moves. If realized volatility exceeds the level assumed in pricing, those hedge adjustments can cost more than the premium received. The discussion is conceptual and simplified; it does not cover detailed pricing, transaction costs, or the full range of structured-product risks.
Key ideas
- A trader can hedge a sold structured-product option by buying a matching option when one is available.
- The difference between the client price and hedge cost can contribute to trading margin.
- When direct hedging is unavailable, a trader may manage option exposure through dynamic delta hedging.
- Higher realized volatility than assumed at pricing can make dynamic hedging more costly.
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# Once the client buys a structured product, what does the trader do? # Once the client buys a structured product, what does the trader do? These are simple questions, i know what is a structured product and how you price it but i'm a bit confused regarding the process. Let's say client buys a simple product for 1Y, guaranteed capital and 100% of the upside. So as a structurer you receive 100 from the client, you put 95 in the ZC, you will have 100 in 1 year. Then you give the 5 to the trading desk for the call but : - Does the trader buy on the market the call the client will have, then he is in the same position than the client ? But in this case he can't hedge as a call seller and it's what he does from what I understood. - Does he create a selling call position in his book and use the 5 to hedge himself ? - Why then would it matter for the pricing desk to have the good price of the call on the market if he doesn't use it to buy a call and only needs to hedge as a seller ? ## Answer by Lliane (score 3, accepted) https://quant.stackexchange.com/a/51603 If a structured product trader can directly hedge in the market, he will usually do it. Here your example is a little too simplified, many structured products have features that cannot be easily hedged in the market because they are path dependant (barriers), or illiquid (typically a 5 years 60% put on a single stock). Let's take your product, but imagine it's on a single stock that doesn't have any options. The structured product trader will have to buy the delta of an imaginary at-the-money call then manage it (buy more stocks if stock goes up, sell them if stock goes down). If he sold you the call at 5 (margin included) thinking the vol would be 30% and the realized vol turns out to be 60% (meaning the call should have been worth 12 for instance), buying and selling stocks to hedge his delta will cost him 12 dollars on average on the life of the product, and he will end up losing 7 dollars. ## Answer by dm63 (score 1) https://quant.stackexchange.com/a/51604 In the simplest case, he books the structured product as a sale of the call at 5, he then enters the market and buys a call at 3, so he pockets 2 on the trade.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.