Call-spread overhedge
Definition · Level 10 · Derivatives pricing
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Replicating a short binary call with 1/ε lots of the (K − ε)/K call spread, so the hedge always pays at least the binary; its cost is built into the price.
Example
Sold a binary paying 1 above 100? Buy 1/ε of the (100 − ε)/100 call spread.
Where Tradecraft teaches it
Level 10 · Derivatives pricing, in the lesson “Digitals & barrier options”: Price and hedge binaries with call spreads, and decompose knock-ins and knock-outs.
Related terms
- Digital optionBinary payoff: a fixed amount if the underlying finishes beyond the strike, nothing otherwise.
- Down-and-in putPut that exists only if the underlying falls through a lower barrier; the option investors sell inside autocallables and barrier reverse convertibles.
- In-out parityKnock-in + knock-out with the same strike, barrier and expiry = the vanilla (ignoring rebates), so each costs less than the vanilla.
- Knock-inBarrier option that only comes alive if the underlying touches the barrier before expiry.
- Knock-outBarrier option that dies if the underlying touches the barrier before expiry, sometimes paying a small rebate.
- One-touchPays a fixed amount if a level trades at any time before expiry; with small drift and continuous monitoring, worth roughly twice the matching…