What is Options Hedging Strategy?

29 January 2025
4 min read
What is Options Hedging Strategy?
whatsapp
facebook
twitter
linkedin
telegram
copyToClipboard

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.

Options Hedging Strategy

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.

Hedging Equities Using Options

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?

Hedging Index 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.

Benefits of Hedging With Options

Options can be a great tool for hedging positions for the following reasons.

  •       The primary benefit of hedging with options is that it minimises the risk. Whether it is a trade or an investment, options can help limit the downside.
  •       Options are also cost-effective and have lower associated costs than futures or stocks.
  •       In some cases, the market conditions may help generate significant returns even on hedged positions.

Conclusion

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.

Disclaimer

The stocks mentioned in this article are not recommendations. Please conduct your own research and due diligence before investing. Investment in securities market are subject to market risks, read all the related documents carefully before investing. Please read the Risk Disclosure documents carefully before investing in Equity Shares, Derivatives, Mutual fund, and/or other instruments traded on the Stock Exchanges. As investments are subject to market risks and price fluctuation risk, there is no assurance or guarantee that the investment objectives shall be achieved. Groww Invest Tech Pvt. Ltd. (Formerly known as Nextbillion Technology Pvt. Ltd) Ltd. do not guarantee any assured returns on any investments. Past performance of securities/instruments is not indicative of their future performance.
Do you like this edition?
ⓒ 2016-2025 Groww. All rights reserved, Built with in India
MOST POPULAR ON GROWWVERSION - 5.7.5
STOCK MARKET INDICES:  S&P BSE SENSEX |  S&P BSE 100 |  NIFTY 100 |  NIFTY 50 |  NIFTY MIDCAP 100 |  NIFTY BANK |  NIFTY NEXT 50
MUTUAL FUNDS COMPANIES:  GROWWMF |  SBI |  AXIS |  HDFC |  UTI |  NIPPON INDIA |  ICICI PRUDENTIAL |  TATA |  KOTAK |  DSP |  CANARA ROBECO |  SUNDARAM |  MIRAE ASSET |  IDFC |  FRANKLIN TEMPLETON |  PPFAS |  MOTILAL OSWAL |  INVESCO |  EDELWEISS |  ADITYA BIRLA SUN LIFE |  LIC |  HSBC |  NAVI |  QUANTUM |  UNION |  ITI |  MAHINDRA MANULIFE |  360 ONE |  BOI |  TAURUS |  JM FINANCIAL |  PGIM |  SHRIRAM |  BARODA BNP PARIBAS |  QUANT |  WHITEOAK CAPITAL |  TRUST |  SAMCO |  NJ