Calculation and mechanics
Hedges can be, for example, bought puts on equity indices or long options on volatility products. Their entry costs are summed and divided by the sold premium of the open short-premium strategies. A value of 20% means that the entry cost of the open hedges equals one fifth of the open short premium.
Over a period, the same principle can be viewed as a budget: premiums collected in the period relative to the spending on hedges in the same period.
Hedge budget = entry cost of open hedges / open short premium x 100
Distinction
The hedge budget measures cost, not protective effect. Whether a hedge actually absorbs the Max Loss of the open short positions in a stress phase depends among other things on the underlying, strike, expiration and size of the hedge position.
The metric is not to be confused with the classic hedge ratio. That describes the size of a hedge relative to the exposure being hedged, not its cost.
Related terms
- Sold Premium (Short premium, sold option premiums)
- Max Loss (Maximum loss, option max loss)
- Option Strategy (Spread, Iron Condor, Covered Call)
- VIX (CBOE Volatility Index)
All market and analytical information is provided for educational and analytical purposes only and does not constitute investment advice or a trading recommendation.