How to use Options for Hedging?
Consider this scenario: you own shares in Reliance Industries Limited (RIL) and have a long-term bullish outlook on the stock’s price. However, there is some recent news circulating in the market that is likely to have a negative influence on RIL’s share price in the near future. How can you use your existing stocks to protect yourself from losses? We’ll try to respond to this question here. We’ll go over how to use options to hedge current positions in this piece. However, before diving into the Options hedging method, it’s important to first grasp the basics of options trading and hedging.
What are Options ?
Options are a type of derivative instrument whose value is determined by the value of the underlying asset. Depending on the type of contract, an option contract offers the holder the right (but not the duty) to buy or sell the underlying asset.
If you own a Call Option, you have the right to acquire the underlying asset on or before the expiration date. If you own a Put Option, you have the option to sell the underlying asset on or before the contract’s expiration date.
How does hedging work ?
Hedging is a risk management approach that involves adopting an opposite position to offset the risk on existing investments. If the hedging transactions wind up losing money, the risk reduction comes at the cost of lower profits. Hedging is typically accomplished through the use of derivative instruments such as futures and options.
Let us now continue our discussion on “How to Use Option to Hedge?” with RIL’s current situation. Buying a Put Option (Right to sell at a predetermined price upon expiry) or selling a Call option is now a simple technique to hedge a long (or buy) position in the company’s shares (Pocket the premium from the buyer of Call Option). But, oh, how I wish it were that simple. Hedging with options has its own set of difficulties. We must evaluate the time of entry, strike price, number of lots to enter with, premium to be paid to enter the option position, and other factors. Here are a few tactics that will be discussed to help you comprehend the various hedging options available.
Two Simple Option Hedging Techniques
In this post, we’ll look at two different options for hedging strategies:
1. Married Put
2. Covered Call
Typically, strategies are created using a minimum of two option positions that are active at the same time. These two tactics, on the other hand, are employed to hedge an existing position.
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What is Covered Call Strategy, and how does it work?
When one is positive on a stock and wishes to protect his position against a short-term decrease in the price of the underlying, a covered call is a popular and widely employed method. To use this technique, you must first take a long position in the underlying stock and then concurrently write/sell one call option for an equal number of shares of the same underlying stock.
Let’s take a closer look at how the covered call strategy works:
1. Assume the business XYZ is the stock under consideration.
2. I purchased 200 shares of this company for Rs. 95 each.
3. The current market price (CMP) of XYZ company’s shares is Rs. 106, and it is trading around its 52-week high, suggesting a price correction.
4. However, rather than quitting at the current price, I want to improve my exit price or point of entrance. In order to accomplish this, I shall employ the Covered Call Strategy.
5. I search for a Call Option Strike Price that is higher than the current Spot Price.
6. As a result, I chose the 110 CE (Call option) strike price, which is now selling at a premium of Rs 4 per share.
7. Days until expiration: 4 days
8. If the option buyer wishes to exercise his right before the expiration date, I shall sell my stock position for Rs. 114 (strike price + premium received). And this is significantly higher than the current spot price of Rs. 106.
9. I’d still make a substantial profit of Rs. 19 (114-95) per share.
10. A substantial 20 percent return on investment (Buy at 95, sell at 114)
11. For example, if the share price of XYZ does not rise above 110 by the time it expires, I will receive a premium of Rs. 4 per share.
12. And my share’s current effective buy price is Rs. 91. (95-4)
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How does the Married Put Strategy work?
A Married Put Strategy is when an investor holds a long position in a company’s stock and buys a put option on the same stock with an equal number of shares. The purpose for purchasing this approach is to guard against downside risk if the underlying asset’s share price falls. This method is appealing since it allows one to reduce his losses if the stock price falls due to unforeseen circumstances.
Let’s look at an example to better grasp this strategy:
1. Assume I purchased 200 shares of XYZ company at Rs. 81 each.
2. The XYZ company’s CMP (Current Market Price) is Rs.98.
3. To mitigate the risk of losing a significant amount of money, I’m considering purchasing insurance against a drop in the price of XYZ corporation.
4. Right now, I’m doing so by purchasing the Married Put Strategy.
5. After conducting extensive research utilizing Option Chain, I have decided to purchase 95 PE (Put option) at a premium of Rs. 2500.
6. The Option is still valid for another 12 days.
7. If a Put option expires worthless and the price of one share of XYZ business is Rs. 100, the Put option is worthless.
8. Then I only stand to lose the Rs. 2 premium, and my share’s buy price rises to Rs. 83 (81 +2).
9. However, I am still making a profit of Rs. 17 (100-83) per share as compared to the CMP.
10. What if the XYZ company’s share price falls to Rs. 85 at the end of the year?
11. I will then get a profit of Rs. 8 (95-2-85) per share on the Put option I purchased.
12. In that instance, the buy price of an XYZ firm share falls to Rs. (81-8) per share, or Rs. 73.
13. In any event, the minimum profit on XYZ business shares is Rs. 12 per share till the option contract expires.
As a result, this method is similar to purchasing a stock insurance policy, and the maximum profit potential is still unlimited, minus the cost paid for purchasing a put option.
Hedging Basics – What is Hedging in the Stock Market?
Hedging has become an important element of any trader’s or investor’s daily routine. It assists them in either protecting their profits or improving their point of entry, or at the very least maintaining their current position while managing volatility. If one wants to comprehend the art of hedging, a thorough comprehension of the concept of options trading and the application of their techniques is essential. This concludes this article. We hope our essay on Options Hedging Strategy taught you something new. Please share your thoughts in the comments box below. Happy Trading and Investing!
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