Explanation

The portfolio exhibits two key characteristics:

1. High unfavorable sensitivity to increases in implied volatility - This means the portfolio has negative vega (vega < 0). When volatility increases, the portfolio loses value.

2. Significant daily losses with the passage of time - This means the portfolio has negative theta (theta < 0). As time passes, the portfolio loses value.

To hedge this portfolio, we need to:

• Increase vega (make it more positive) to offset the negative vega exposure
• Increase theta (make it more positive) to offset the negative theta exposure

Option analysis:

• Short-dated options: Have higher theta (time decay works faster)
• Long-dated options: Have higher vega (more sensitive to volatility changes)

Strategy A: Sell short dated options and buy long dated options

• Selling short-dated options gives positive theta (benefits from time decay)
• Buying long-dated options gives positive vega (benefits from volatility increases)
• This combination effectively hedges both the negative theta and negative vega exposures

Why other options are incorrect:

• B: Would increase negative theta and negative vega
• C: Would increase negative vega exposure
• D: Would increase negative theta exposure