"When dealing with a large-size position, dealer, upon exercise, synthetically become short an out-of-the-money option."
How does this work, I cannot see why this happens synthetically in particular?
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2$\begingroup$ pls could you give us more context? dealer is exercising an otc option? listed option? cash settled option? physically settled option? etc $\endgroup$– dm63Commented Mar 15, 2016 at 15:24
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1$\begingroup$ FYI quote if from Page 27 of Dynamic Hedging by N. Taleb, I believe he is duscussing early exercise of American options ... $\endgroup$– nbbo2Commented Mar 15, 2016 at 18:19
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$\begingroup$ tks noob i posted an answer based on that $\endgroup$– dm63Commented Mar 15, 2016 at 18:32
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2 Answers
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Here's one scenario: dealer is long a deep in the money American put (say strike is K and the current stock price is S < K ), versus being short a european put with the same strike and final expiration. If the dealer exercises early the American put, he is now short the European put at K with a short stock hedge against it. Thus he is synthetically short a European call struck at K. ("synthetically" via put-call parity). I'm not sure if that's what is being referred to.
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Here's the example of what is in the quote: dealer is long an ITM call. As a hedge the dealer is also short OTM put (with the same strike) and short stock. This is a "riskless" position, equivalent of a bond.
The underlying pays a dividend, and a day before the ex-date dealer exercises the call. The shares that dealer received from exercise are netted against his existing shorts to zeros, which leaves the dealer short an OTM put.
answered Mar 15, 2016 at 20:29