Investors utilise hedging methods to decrease their risk exposure if a portfolio asset experiences a sudden price decline. Hedging tactics, when used correctly, reduce uncertainty and limit losses while not materially affecting the prospective rate of return.
Hedging safeguards an investor’s portfolio against loss. Hedging, on the other hand, results in reduced returns for investors. As a result, hedging with options is a strategy that should be employed to protect against losing money rather than to generate money.
Typically, investors buy securities that are inversely related to a vulnerable item in their portfolio. In the event that the vulnerable asset’s price falls, the inversely associated security should rise in the other direction, functioning as a hedge against potential losses. Some investors also buy financial instruments known as derivatives. Derivatives, when implemented strategically, can restrict investors’ losses to a set level. A put option on a stock or index is a traditional hedging tool.
An option has value only when the strike price is met (known as an at-the-money option) or exceeded (known as an in-the-money option). Before this, the option has no intrinsic value and is therefore worthless.
There are two choices accessible to you:
Call options confer the right, but not the duty, to purchase an asset. If you feel the market price will climb from its current level, you would buy a call option; if you believe it will decrease, you would sell a call option.
A call is a very popular and often used technique when one is positive about the stock and wants to hedge against a short-term decrease in the price of the underlying. To implement this strategy, one must already hold a long position in the underlying company and concurrently write/sell one call option for an equal number of shares of the same underlying stock.
This method is more effective when one already has a long position in the company’s stock and wants to enhance his entry or exit price.
A put option allows you to sell a stock at a specific price within a specified time frame. For example, suppose Abel, an investor, purchases a stock at $14 per share. Abel expects the price to rise, but if the stock price falls, she can pay a small fee ($7) to ensure she can execute her put option and sell the stock at $10 within a year.
Here, an investor has an existing long position in a company’s shares and purchases a put option with an equal number of shares. The purpose of purchasing this approach is to safeguard against downside risk if the underlying asset’s share price falls. This method is appealing since it allows one to limit his loss if the stock price falls due to unforeseen circumstances.
If the value of the stock she acquired increases to $16 in six months, Abel would not be able to execute the put option and will lose $7. However, if the stock’s value falls to $8 in six months, Abel can sell the stock she purchased (at $14 per share) for $10 per share. Abel’s losses were limited to $4 per share by using the put option. Abel would lose $6 per share if she did not have the put option.
Steps to start hedging with options
- Find out more about options trading.
- Make an account
- Select an options market to trade-in.
- Choose from daily, weekly, or monthly options.
- Choose a strike price and position size that will allow you to balance your exposure.
- Your deal should be opened, monitored, and closed.
How does Hedge Protect the investors?
As shown in the above instance, the maximum loss on the downside is limited to Rs. (-14), whilst the maximum profit on the upside is infinite. This is because the maximum loss on the option is limited to Rs.4, which is the option’s premium. Regardless of how high the stock goes, that is your maximum loss on the option. On the plus side, your net earnings begin when your option premium cost of Rs.4 is covered. Well, what about the risk of failure?
Keep in mind that a put option is a right to sell. When you purchase the Tata Motors 370 put, you are essentially purchasing the right (but not the responsibility) to sell Tata Motors at Rs.370. So you have a loss of Rs.10 on the transaction (380-370), which is the difference between the price at which you purchased the shares and the price at which you purchased the put option. You add Rs.4 as your sunk cost, which you paid as an option premium. That gives you a total loss of Rs. (-14), which is the maximum loss you will incur even if Tata Motors’ stock price falls to Rs.100.
But what happens when the option expires? If the price movement goes against you, you may simply sell the stock and the option for a maximum loss of Rs (-14). Alternatively, you might profit from the put option after the stock price approaches the support level. If you don’t want to do either of these things, you can just keep buying a new choice every month, which will cost you roughly 1% per month.
Hedging with options has become an essential component of any trader or investor’s daily activities. It enables them to either secure their profits, enhance their point of entry, or at the very least retain their current position while managing volatility.
A thorough comprehension of the notion of options trading and the application of its techniques is essential for a thorough understanding of the art of hedging.