Static Options Replication

Abstract

This article presents a practical and useful method for replicating or hedging a target stock option with a portfolio of other options. It shows how to construct a replicating portfolio of standard options with varying strikes and maturities and fixed portfolio weights. Once constructed, this portfolio will replicate the value of the target option for a wide range of stock prices and times before expiration, without requiring further weight adjustments. We call this method static replication. It makes no assumptions beyond those of standard options theory.You can use the technique to construct static hedges for exotic options, thereby minimizing dynamic hedging risk and costs. You can use it to structure exotic payoffs from standard options. Finally, you can use it as an aid in valuing exotic options, since it lets you decompose the exotic option into a portfolio of standard options whose market prices and bid-ask spreads may be better known.

JEL Classification: G13