Explanation:
The portfolio suffers from "high unfavorable sensitivity to an increase in implied volatility", which means it has a negative (short) Vega position. To hedge this, Twine needs to add positive (long) Vega to his portfolio. The portfolio also experiences "significant daily losses over time", which means it has a negative (short) Theta position (time decay). To hedge this, Twine needs to add positive (long) Theta to his portfolio.
Therefore, Twine needs a strategy that is Long Vega and Long Theta.
By buying long-dated options, Twine gets a large positive Vega and a small negative Theta. By selling short-dated options, Twine gets a large positive Theta and a small negative Vega.
The net effect of selling short-dated options and buying long-dated options (a calendar spread) results in both a net positive Vega and a net positive Theta, which perfectly hedges both risks in his portfolio.
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Q.60 Mark Twine, FRM, owns a portfolio of stocks that exhibits high unfavorable sensitivity to an increase in implied volatility. Twine has also experienced significant daily losses over time. As a market analyst, which of the following hedging strategies would you recommend to Twine?
A
Buy both long-dated and short-dated options.
B
Sell both short-dated and long-dated options.
C
Buy short-dated options and sell long-dated options.
D
Sell short-dated options and buy long-dated options.
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