Options are derivative contracts that provide traders with great flexibility. Traders can use options to benefit from numerous market conditions and hedge their existing positions and investments. In this blog, we will examine the options hedging strategy and how to trade it.
The first part of an options hedging strategy is understanding what is a hedge. A hedge refers to an investment that helps mitigate the risk of the existing position. The gains from one investment offset the losses from another, thus mitigating the risk. A hedge may not help generate significant returns, but it can help limit losses or bring the investment to break even.
Options are financial instruments that give the holder the right but not the obligation to purchase or sell a security at a predetermined price on a specific date. There are two primary types of options contracts:
Call option: A call option gives the buyer the right but not the obligation to buy a security at a predetermined price on a specific date. The value of the call option rises with an increase in the value of the underlying asset and vice versa.
Put option: A put option gives the buyer the right but not the obligation to sell a security at a predetermined price on a specific date. The value of the put option increases with a fall in the value of the underlying asset and vice versa.
Several options hedging strategies make use of both call and put options. Hedging strategies can be used to hedge an investment in equities, indices, commodities, or currencies.
Equity investments make up a significant chunk of many investor portfolios. Deploying hedging strategies can help minimise the risk. Common ways to hedge an equity position include either going long on a put or short-selling a call option.
A short-call hedge, also known as a covered call, is a hedging strategy in which the trader sells call options of the owned stock. This options hedging strategy limits downside risks and allows the trader to regularly pocket the premium if the stock price does not rise significantly. If the stock price increases, the gains from the equity position will offset the losses from the hedge.
In a long put hedge, the trader purchases a put option if the price is expected to fall. If the stock price falls below the strike price of the put option, the option’s premium will increase and offset the losses of the equity position.
Let’s understand the options hedging strategy better with the help of an example.
A trader owns 1,000 shares of company ABC. The trader expects the price of ABC to fall from Rs 100 to Rs 90. To minimise the impact of the fall in stock price, the trader decides to purchase a put option. The trader purchases a put option of 95 strike price which is trading at Rs 10. The lot size of the put option is 1,000 shares.
The price of ABC fell from Rs 100 to Rs 90 which resulted in a loss. However, since the stock price slipped, the put option’s premium swelled from Rs 10 to Rs 18 which minimised the loss.
Loss from ABC: (100-90) x 1,000 = Rs 10,000
Profit from hedge: (18-10) x 1,000 = Rs 8,000
Net loss = 10,000 – 8,000 = Rs 2,000.
From the example, we can see how the hedge helped reduce the loss from Rs 10,000 to Rs 2,000. In case the stock price had moved higher, the profits from the position would offset the losses of the put option.
Also Read : What is Strike Price in Options?
Options are often used for speculative bets on indices. However, traders can also use index options to hedge positions. If an investor has a large portfolio comprising several stocks of a particular index, then index options can be used to hedge the position. Additionally, traders can use options hedging strategies to effectively trade indices in volatile market conditions.
The short straddle is a common hedging strategy often used in indices. In this strategy, the trader sells a call and a put option with the same strike price and the same expiry. The strategy is deployed when the market is not expected to make any significant moves. However, if the market picks up a trend, the losses from one leg will be offset by the gains in the other.
Options can be a great tool for hedging positions for the following reasons.
Although trading options can appear to be complex, getting a good understanding of how these contracts work can help investors hedge their investments effectively. The importance of hedging cannot be understated in volatile and uncertain market conditions. Having options hedging strategies in place can help minimise losses.
Disclaimer: This content is solely for educational purposes. The securities/investments quoted here are not recommendatory.