Sharekhan Blog

Option Hedging Strategies

  • Feb 22, 2024

In this blog post, we'll cover the basics of option strategies hedging and dive into some common option strategies that can be used to protect their investments.

What is Options Hedging?

As with any other investment, options trading also has its risks. On the other hand, as opposed to stocks where you have a maximum loss limit (since the stock price can only go down to zero), options trading leads to not less than unlimited losses if handled inappropriately.

It is at this stage that the options hedging needs to kick in. In essence, it entails the employment of another investment instrument to hedge against risks attached to an existing position. Such actions enable investors to safeguard their assets from potential losses and maintain overall risk minimization.

Why Use Option Hedging Strategies?

Options and hedging strategies are essential in reducing risk in the portfolio of an investor. They ensure that investors keep themselves from variances in the markets and also in unpredicted situations, making them feel secure.

In addition, hedging techniques may in effect, produce positive yields by way of leveraging the opportunities to increase returns while managing risks. This draws options trading to the conservative as well as to aggressors.

Options Explained

The value of options is considered only when the strike price is met, known as the money or in -(over)-money option, and only if under exceeds the above exercise amount. Before meeting this strike price, the options have no fundamental or inborn value at all and are thereby valueless before any of these.

In addition, as options get away from expiration and farther, these are considered cheaper; the same is true for money.

There are two choices accessible to you in this.

1.    Call Options

The option of calls only gives the privilege to buy an asset and never the burden. If you believe that the market cost would increase from its recent level, it implies that you are for the call option, and if there is a belief in possible downward movement of prices, then selling calls can be done.

The call, as they say, is a frequent strategy that people use when confident about a stock and want to protect it from an abrupt price decrease in its underlying. For the strategy to be successful, one must own a position in an underlying business and concurrently write/sell one call option for an equal number of company shares on the same stock.

The drawback of this method is that it works well when one already holds a long position on the company’s stock and has an eye toward establishing a better entry/exit point.

2.    Put Options

Put Options is one of the other Option Hedging Strategies that engage your selling stock at a determined price during an elapsed period.

For instance, XYZ, as an investor, buys a stock at $ 10 per share. XYZ put option ensures that they will receive a fixed strike price on the future share prices after six months, though XYZ expects to go up, and if they fall, then there would be small fees involved. This will guarantee them offloading the stock anytime in late October, towards when they can sell it at an elevated cost.

A long investor who has purchased shares of the company. This option hedging development aims to protect the risk that has to do with drawbacks in an asset’s price. In addition, it is appealing as an investor who uses this strategy can reduce losses if stock prices fail due to unpredictable situations.

What are the Steps to Start Hedging with Options?

  • Let's delve into exploring options within capitalism. Firstly, we need to set up an account to engage in trading activities.
  • Next, we'll need to choose a specific options market where we'll be conducting our trades.
  • The market having been chosen, one needs to establish the frequency with which our trades will operate, either daily, weekly, or monthly.
  • This is followed by the all-important point where a strike price and size of position must be chosen. This decision is therefore necessary since it contributes to the reduction of our exposure risk.
  • Following this, we then go ahead and press the ‘trade’ button to execute a trade and open the deal.
  • We are going to have to keep a close eye on our positions as trading progresses since markets will not wait for us.
  • Finally, the deal is sealed, which needs continuous monitoring.

If we proceed according to these steps, then options trading can be actively practised within the confines of capitalism.

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The Bottom Line

By now, you should have a basic understanding of options hedging strategies and how they can be used to minimize risk and enhance returns in your investment portfolio. Keep in mind that, as with any form of trading, it is important to thoroughly research and understand the risks before implementing any strategy.

Team Sharekhan
by Team Sharekhan

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