Any trade that you implement in the markets carries a certain degree of risk. For instance, if you purchase a stock assuming that its price will increase in the next month, there is always the risk that the stock's price may fall instead, leading to a loss. To counter this risk, you can take an opposite (or short) position in derivatives like options contracts. This is one of the simplest examples of options hedging.
If you are not sure what hedging is and how you can use options for this purpose, this article can help you out. However, to understand how option hedging strategies work, it is essential to first understand what options are and how they work.
Understanding options contracts
An options contract is a type of derivative instrument. This means that it derives its value from underlying assets like equity shares, indexes, currencies or commodities. Both futures and options are derivatives, but the key difference is that with options, the buyer has the right to buy or sell the underlying asset on a specific date at a specific price (known as the strike price). They are not obligated to do so.
There are two types of options depending on the right that they offer — namely, call and put options. Call options offer you the right to purchase the underlying asset. On the other hand, put options allow you to sell the underlying asset. You can use this feature to your advantage to begin hedging with options.
What is hedging in options trading?
Hedging with options is the process of taking an offsetting or opposite position in the options market to protect your position in the underlying asset’s market. By taking a contrasting position in the options market, you are financially protected from enduring steep losses even if the price of the asset moves in an unfavourable direction. This is because a loss in the underlying asset may result in profits in the options market — effectively reducing the overall loss and nearly resulting in a net zero. Sometimes, options hedging strategies may also result in a net profit.
Another way to use options contracts for hedging your trades is to implement multi-legged options trading strategies. Here, you take two or more contrasting positions in the options market simultaneously. So, you are financially protected to a certain extent, no matter the direction in which the market moves.
How to hedge with options?
Now that you know what hedging is, let us examine how to hedge your trades with options. The following options hedging strategies are generally used by traders in varying scenarios to meet different trading objectives.
1. Protective put
In a protective put strategy, you purchase put options for an underlying asset that you already possess. If the asset’s price rises, you can profit from the upward movement in the original market. However, if the underlying asset’s price declines, the put options will become profitable, thereby setting off a part of the losses in the original market.
2. Covered call
A covered call is an options hedging strategy where you sell call options for an underlying asset that you already own. If the asset’s price rises above the strike price, your profit potential is limited because you may miss out on higher market gains. However, if the asset’s price falls, the call options you sold will expire worthless, and you can still profit from the premiums earned.
3. Collar
To implement this type of options hedging strategy, you need to purchase a put option and sell a call option simultaneously. It effectively combines a protective put with a covered call, so your profits and losses are both limited. By reducing the upside gain and downside risk, you can protect your profits without selling the underlying asset.
4. Straddle and strangle
In these strategies, you buy a combination of put options and call options with the same expiry. However, while a straddle uses options with the same strike price, a strangle involves options with different strike prices. These options hedging strategies are useful when you expect a substantial movement in the underlying asset, but are not sure of the direction of the move.
5. Butterfly spread
In this method of hedging with options, you can either use the long put (where you buy one ITM put option, sell two ATM put options and buy another put OTM option) or the short call spread (where you sell one ITM call option, buy two ATM calls and sell another OTM call option). These strategies can be profitable if there is low volatility in the underlying asset.
How does a hedge protect investors and traders?
A hedging strategy using options can benefit traders and investors in many ways. Check out the key benefits of using options to hedge any position in the market.
- Reduced risk: Using options to hedge any existing or new positions in the market can help reduce the overall downside potential for any trade. The risk can also be quantified easily, so you can be prepared for the worst-case scenario and assess if you can withstand that risk.
- Cost efficiency: Options can make hedging quite cost-effective because you do not need to pay the entire transaction value upfront. Instead, you only need to pay the options premium if you are buying the derivatives.
- Potential for higher returns: In addition to limiting and defining the risk, hedging with options can also be profitable in the right market conditions. If the price moves favourably, your profits could be substantial.
Conclusion
Hedging with options is a prime example of how you can use options trading to not only leverage options’ price movements but also to limit the downside risk in the underlying asset. For beginners, this may be difficult to grasp and implement. So, if you are new to the options market, it is best to practise implementing different options hedging strategies using simulations before attempting to trade live in the market.
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