Options Hedging Strategy Explained: Imagine if you were holders of the shares of Reliance Industries Limited (RIL) and you have a bullish view on the share price of same over the long term. However, there is some current news that are doing rounds in the market and which are likely to have a negative impact on the share price of RIL over the short term.
How so can you use your existing shares to hedge your losses? We will try and answer this question here. In this post, we’ll cover how does one use options to hedge his existing positions. However, before we look into the Options hedging strategy, let us understand in brief the concept of Options trading and Hedging.
Table of Contents
What are Options?
Options are a derivative product that derives its value from the value of the underlying asset. An option contract gives the holder, the right (not an obligation) to buy or sell the underlying asset depending on the kind of contract they hold.
If you are the holder of the Call Option, then you have the right to buy the underlying asset on or before expiry. And if you holder of the Put Option, then you have the right to sell the underlying asset on or before the expiration of the contract. You can read this article to understand the basics of options trading.
What is Hedging?
Hedging is a risk management strategy that is employed to offset the risk on the existing investments by taking an opposite position. The reduction in risk also comes with the condition of reduced profits if the hedging trades end up making losses.
In general, Hedging is done using derivative products like Futures and Options. You can read this article to understand the basic concept of hedging in detail. However, through this discussion, we will be focusing on Using Options for Hedging.
Now, let us continue with our discussion on “How to Use Option to Hedge?” with the existing position of RIL. Now, the simple way to Hedge a long (or buy) position in the shares of the company is with buying Put Option (Right or sell at a predetermined price upon expiry) or to sell a Call option (Pocket the premium from the buyer of Call Option).
However, if only, it were as simple as that.
Hedging using Options comes with its own set of challenges. Time of entry, strike price to enter, number of lots to enter with, premium to be paid to enter the option position, etc., are few questions which we need to consider. Here are few strategies that we will be discussing to understand the hedging strategies which can be used.
Two Easy Option Hedging Strategies
Here are two Options Hedging Strategy that we will be discussing in this post:
- Covered Call &
- Married Put
Usually, the strategies are designed with the help of a minimum of two option positions running simultaneously. But these two strategies are used when one is looking to hedge the existing position.
What is Covered Call Strategy?
A covered call is a very popular and most commonly used strategy when one is bullish on the stock and wants to hedge his position against a decline (short term) in the price of the underlying.
To execute this strategy, one needs to have an existing long position in underlying stocks, and simultaneously write/sell one call option for an equal number of shares of the same underlying stock.
Note: This strategy is more fruitful when one is having an existing long position in the shares of the company and wants to either improve his entry price or exit price.
Let us understand how the covered call strategy works:
- Assume the Stock under consideration here is XYZ company.
- I have bought 200 shares of this company at a price of Rs. 95
- The Current Price (CMP) of shares of XYZ company is Rs. 106 and it is trading near its 52 weeks high and we could see some correction in its price.
- But rather than exiting at the existing price, I am looking to better my exit price or improve my point of entry. In order to do so, I will be implementing the Covered Call Strategy.
Now moving forward,
- I look for a Call Option Strike Price that is above the Spot price.
- Therefore, I choose the 110 CE (Call option) strike price and it is trading at a premium of Rs 4
- Days left for expiry: 4 days
- Upon expiry, if the buyer of the option wants to exercise his right, then I will be selling my stock position at Rs. 114 (strike price + premium received). And which is way above the current spot price of Rs. 106.
- I would still be making a sizable profit of Rs. 19 (114-95) per share.
- A sizable return of 20% on investment (Buy at 95, sell at 114)
- Say, if upon expiry if the share price of XYZ does not go beyond 110, I stand to pocket the premium of Rs. 4 per share.
- And the effective buy price of my share now is Rs. 91 (95-4)
Overall with the help of this strategy,
- Either the profit potential gets increased or
- We improve our entry price of the existing position.
What is Married Put Strategy?
Under Married Put Strategy, an investor has an existing long position in the shares of a company and simultaneously buys a put option for the same with an equal number of shares.
The rationale behind buying this strategy is to protect the downside risk just in case the share price of the underlying asset goes down. This strategy is very attractive as one can limit his loss just in case the stock price goes down because of unforeseen scenarios.
Let us understand this strategy with the help of an example:
- Assume, I bought 200 shares of XYZ company at a price of Rs. 81
- The CMP (Current Market Price) of XYZ company is Rs.98
- To cover my risk of losing handsome returns, I am looking to take insurance against the fall in the price of XYZ company.
- Now, I do so by buying Married Put Strategy.
- After doing careful analysis by using Option Chain, I decide to buy 95 PE (Put option) by paying a premium of Rs. 2
- The Option still has 12 days to expiry
- If upon expiry of a Put option, it expires worthless and the price of one share of XYZ company is Rs. 100
- Then, I just stand to lose the premium of Rs. 2, and the buy price of my share trails up to Rs. 83 (81 +2)
- But compared to the CMP, I am still making a profit of Rs. 17 (100-83) per share
- And if the share price of XYZ company upon expiry, comes down to Rs. 85
- Then, on the Put option bought, I will be making a profit of Rs. 8 (95-2-85) per share
- In that case, also the buy price of XYZ company share reduces to Rs. (81-8) i.e., Rs. 73 per share.
- In any case, the minimum profit on shares of XYZ company is Rs. 12 per share, till the expiry of the option contract.
Therefore, this strategy is like buying an insurance policy against the weakness in the share and the maximum profit potential is still limitless minus the premium paid for buying a put option.
Hedging becomes a very integral part of any trader’s or investor’s day-to-day activity. It helps them to either protect their profits or improve their point of entry or to at least maintain their existing position and manage the volatility.
A proper understanding of the concept of options trading and the implementation of their strategies goes a long way if one wants to have a proper understanding of the art of hedging.
That’s all for this post. We hope you have learned something new from our article on Options Hedging Strategy. Let us know your views in the comment section below. Happy Investing and Trading!
Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!
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