I'm reading the book "Option Volatility and Pricing" by Natenberg and there is a paragraph I'm having trouble understanding.
Chapter 7 (Risk Measurement 1), Page 98, Paragraph 2:
The value of a stock option will also depend on whether a trader has a long or short stock position. If a trader’s option position also includes a short stock position, he is effectively reducing the interest rate by the borrowing costs required to sell the stock short (see the section “Short Sales” in Chapter 2). This will reduce the forward price, thereby lowering the value of calls and raising the value of puts. As a consequence, the trader who is carrying a short stock position ought to be willing to sell calls at a lower price or buy puts at a higher price. If the trader either sells calls or buys puts, he will hedge by purchasing stock, which will offset his short stock position.
The fact that option values depend on whether the trader hedges with long stock or short stock presents a complication that most traders would prefer to avoid. This leads to a useful rule for stock option traders:
Whenever possible a trader should avoid a short stock position.
My Doubts are:
- What exactly is the meaning of "If a trader’s option position also includes a short stock position"? Why or under what conditions would you say an option position "includes" a short stock position?
Is he talking about delta hedging? Is it implicitly assumed that option traders will delta hedge their portfolios? I'm skeptical because up until this point in the book no mention is made of delta hedging.
- Why would the valuation of an option depend on the existence of short stocks in the portfolio as mentioned in the statement: "As a consequence, the trader who is carrying a short stock position ought to be willing to sell calls at a lower price or buy puts at a higher price"
I believe that valuation of a fincancial instrument would be independent of what you already hold or your cost to finance the purchase.
Again it seems, as explained in the next sentence, that either selling calls or buying puts will implicitly involve a long stock position for the purpose of delta hedging. Hence an existing short stock position combined with either selling calls or buying puts, and hence going long stock in effect neutralises the short position and hence saves us from the borrowing costs.
Is this a fair analysis? Again it boils down to the question of whether delta hedging is ubiquitous enough for it to be implicitly assumed.
- The last line says "Whenever possible a trader should avoid a short stock position."
I understand this is obvious just looking at the borrowing cost. Is that it? Are there subtleties that I'm missing here? Can anyone expand on why else would a trader want to avoid a short stock position?