Suppose you were replicating a two-period put option in a binomial tree. Then, the replicating strategy involves an initial short position in the underlying stock that
A) is held unchanged to maturity.
B) is increased in size (i.e., becomes more short) after one period.
C) is increased in size (i.e., becomes more short) if the price goes down in the first period and decreased in size (becomes less short) if the price goes up in the first period.
D) is decreased in size (i.e., becomes less short) if the price goes down in the first period and increased in size (becomes more short) if the price goes up in the first period.

Question

Quizplus · Accepted Answer

In a two-period put option replicating strategy, the initial short position in the underlying stock is increased (i.e., becomes more short) if the price goes down in the first period and decreased (i.e., becomes less short) if the price goes up in the first period. This is because in the case of a put option, we want to increase our short position when the price of the underlying stock goes down so that we can benefit from the option's payoff at maturity. On the other hand, we want to decrease our short position when the price goes up as the option's payoff decreases in this scenario. Therefore, Choice C is the best option among the given choices.

Suppose You Were Replicating a Two-Period Put Option in a Binomial