||We use dynamic hedging to replicate the short put positions of common stocks and thelong put positions of equity index. The strategy is developed based on the fact that the volatility of average constituent stocks is greater than that of the index, and the aggregate|
movement of the constituent stocks becomes the movement of the index. Therefore, we expect the long-short volatility strategy to deliver stable returns.
In this study, we first employ Monte Carlo simulation methods to create paths for the underlying securities and the corresponding index. Then, we use Black-Scholes delta-neutral
dynamic hedging strategy to create synthetic options for the long-short put positions.Specifically, we conduct the dynamic replication strategy to form long put option of TSEC Taiwan 50 equity index and short options of its constituent stocks.
Finally, we pick the TSECTaiwan Mid-Cap 100 Index and replicate the long-short volatility strategy again. This time the target constituents screening criteria are high beta and high historical volatility.
The empirical studies show that: (1) The correlation coefficients between stock pairs are reciprocally related to the standard deviations of strategy returns. (2) The main source of losses is performance deviation of the price of small-sized stocks and the index. (3) The return of the strategy for portfolios excluding small cap stocks will be improved. (4) The loss will decline if we apply short strip strategy on those stocks which prices perform worse than the index. (5) The higher the volatility of the stocks we select, the greater the dynamic hedging premium we can get. (6) If we pick the high beta stocks to avoid the trend of stock
prices diverging from the index, then the strategy yields higher returns.