Everything You Must Know About Options Hedging
Hedging methods are usually used by investors to minimize their exposure to market volatility and risks. This is done when the price of a portfolio asset declines sharply all of a sudden. When used properly, Hedging methods can decrease the limit losses and uncertainty while keeping the rate of returns unaffected. In this blog, we will discuss everything you need to know about options hedging including what it is and how it can be done properly. Keep reading!
What is Hedging With Options?
Hedging is an important process that helps in safeguarding your portfolio against various market risks. However, it can sometimes result in minimizing the returns of your portfolio. This is the main reason why hedging should be treated as a way to prevent money loss instead of a way to generate returns. It should be done very carefully.
Generally, investors prefer buying securities that are inversely proportional to the vulnerable items or assets in their portfolio. In the situation where the price of that vulnerable item falls, the inversely proportional security rises in the positive direction. This works as a hedgehog against potential losses.
Moreover, some traders also invest in instruments called derivatives. When implemented strategically, these financial instruments can limit the losses of investors to a fixed level. A put option is a traditional hedging tool used by the majority of investors. Let’s now discuss how options hedging is done correctly.
Step-by-step Procedure for Hedging with Options
- Learn about options trading thoroughly.
- Create a trading account.
- Analyze and select the options trade market.
- Select from monthly, weekly, or daily options.
- Select an option strike price and position it in a way that will help you balance your risk exposure.
- Open the deal, monitor it properly, and close it.
How Does Hedging With Options Protect the Investors Against Losses?
For hedging to work properly, two investment instruments should be inversely proportional to each other. So, when the value of one investment falls, the value of another must rise. Let’s try to understand it with the help of an example.
Suppose an investor buys 100 shares of ABC stock at Rs. 100. At this time, the investor is behaving bullishly but he is also afraid that the stock price may drop all of a sudden. Therefore, to hedge against this potential loss of stock price, the investor purchases a put option at a rate of Rs. 1 per share. This put option expires in a couple of months and has a strike rate of Rs. 90. This allows the investor to sell the ABC shares at Rs. 90 any time before the expiry of the Put option.
Now, suppose in three months ABC stock is trading for Rs. 110. In this scenario, the investor will not use his put option because he will already gain Rs. 10 due to the increase in stock price from Rs. 100 to Rs. 110. But he will lose the price of Rs. 1 per share he paid for purchasing the put option. As you can see, his total gain will be Rs. 9 per share after reducing the amount he used to buy the put option.
Now, take another scenario where the stock ABC is trading at Rs.50 after three months. In this case, the investor will use his put option, which will allow him to sell his stocks at Rs.90 instead of Rs.50. In this case, he loses only Rs.11.
Hedging with options is an important concept followed by investors on a day-to-day basis. It allows them to enhance their profit and safeguard their investments against potential losses. A thorough understanding of options trading along with proper hedging techniques is essential for hedging with options. We hope this information helps!