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Hedging in Option trading

Mastering Hedging in Option Trading: Master plan for Risk Management in 2024

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In this blog, we will come to know about the Hedging in Option trading and before getting into it, we will give a brief introduction on Option trading and also the link to the blog on Option trading.

What is Option Trading ?

Option trading entails the buying and selling of securities known as options, which are contracts that allow traders to acquire an asset or sell it at a particular price for a given period. There are two main types of options: Removed services are call options, which are essentially the right to buy the asset, and put options which are the right to sell the asset. These are mainly employed for futures and options and can act as effective insurance against certain market risks or for gambling with price trends.

Another advantage of trading options is that you can use a relatively small amount of money to control a larger amount and possibly earn more. But at the same time, the use of this leverage also implies higher risk, which should underline the importance of risk management aspects.

The basic forms of options trading strategies include the covered calls, protective puts, while the advanced forms include such strategies as the straddles, strangles, and spreads. All of these strategies provide different risk-reward proposition and are applicable under certain market conditions.

There is essential information that is required to trade options, including market sentiments, the movement of the underlying commodity and the characteristics of options. It is also apparent that factors such as market volatility and time decay could have a large influence on the option prices and performance.

Importance of Risk Management

The talk made it abundantly evident that controlling risk is essential to trading and investing as well as a major factor in determining sustainability and profitability over the long run. It comprises identifying and taking proactive measures to mitigate risks that could jeopardise an investment or a business opportunity. Risk management is crucial for safeguarding funds, limiting losses, and optimising uncertainties by making plans for how to respond to them should they arise.

Overview of Hedging

Hedging in Option Trading

Definition of Hedging:

Hedging is a strategy used to minimize risks that may be associated with investment or other business activities. It might as well be regarded as paying a premium for the coverage of your cash and valuables. At base, hedging is defined as a way, in which you take a position or invest, in such a manner as to offset potential loss in another investment or risky venture.

For example: Suppose I own Tata Motors shares, but I fear its price may decline in future. I can also purchase PUT option which is likely to increase its value in case of decline in tata motors stock price. In this way, even if you end up losing money in stock value, hopefully, profit from Options will make up for that loss.

In simpler terms, Hedging refers to an insurance for your financial or you are welcome to call it your money choices. It will not guarantee that you will not be facing any losses but make sure that the impact of these losses is minimized and you are placed in a better standing in the market, especially in the event that there are shifts which you cannot control.

Purpose of Hedging

Hedging aims to shield you from unexpected losses and lower financial risk. Think of it as a way to soften the blow when plans go awry. By using hedging tactics, you build a safety net that can help lessen the impact of bad market shifts or unfavourable changes in conditions.

For example: Suppose I own Tata Motors shares, but I fear its price may decline in future. I can also purchase PUT option which is likely to increase its value in case of decline in tata motors stock price. In this way, even if you end up losing money in stock value, hopefully, profit from Options will make up for that loss.

At its core, hedging is about handling uncertainty and making sure a possible bad outcome doesn’t throw off your overall money situation. It’s not about steering clear of risk , but more about keeping it in check and bringing it down to a level you can handle.

What is Hedging in Option Trading with example

In option trading, hedging has an influence on protecting investments against possible losses. This strategy uses options to balance out risks in current investments. It works like a safeguard to reduce the effect of unfavourable price changes.

Example:

Let’s say you own 100 shares of Company XYZ, which trades at $50 per share right now. You’re concerned that the stock price might go down and want to protect your investment.

Using a Protective Put:

  1. Current Situation:
    • Holding: 100 shares of XYZ
    • Current Share Price: $50
    • Total Value: $5,000
  2. Hedging Action:
    • Buy a put option with a strike price of $45, which expires in one month. With this we are able to sell the shares at 45$ each no matter how low the market price of the share drops.
  3. Put Option:
    • We are buying put option at $2 per share, so the total cost of 100 shares would be $200.
  4. Possible Outcomes:
  • Falling Stock Price: If we say, XYZ share drops to 40$ per share, without having the put option the shares would be worth 4000$ that is 1000$ loss and if you have the put option, you can sell the same at 45$ each, which will cut your loss to 500$ (5000$ initial value subtract 4500$ from selling at 45$). When you add the $200 you spent on the put option, your total loss would be $700.
  • If the Stock Price Rises: If XYZ goes up to $55 per share, you don’t need to use the put option. Your shares would be worth more, though the $200 you spent on the option is a cost you’ve taken on. Still, the hedge gave you protection against possible losses.

This method gives you a backup plan to cut down on possible losses while letting you gain from rising prices.

Basic Hedging Strategies

Basic hedging strategies are techniques you used to protect your capital/investments and manage the risk. Below are few key ones:

  1. Covered Call:
    • In covered call, firstly you own a stock and sell a call option of that same stock, which means that you are agreeing to sell your stock at a specific price (strike price) if the person buying the option decides to exercise it.
    • This strategy helps in generating extra income through the premium received by selling the call option. Suppose the stock price stays below the strike price, you will get to keep the premium and your shares. If the stock prices gets above the strike price, you might have to sell the stocks but still will get benefit from the premium.
  2. Protective Put:
    • You will own a stock and will have to buy a put option for it. A put option will give you the right to sell your stock at a specific price (strike price) within a specified duration.
    • This strategy will provide insurance against a decline in the share price. If the stock price gets down below the strike price, you can sell at the higher strike price, which will limit your losses.
  3. Cash-Secured Put:
    • In this case, you sell a put option while keeping enough amount of cash in hand to buy the stock if option is exercised.
    • In this strategy, income can be generated through the premium received from selling the put option. If the stock price sustains above strike price, you will keep the premium. If it gets below, you will have to buy the stock at the strike price, as we were ready with the amount of cash.

These are the basic strategies which offer ways to manage risk and enhance your investment approach, which in short help you save your assests while earning additional income.

Advance Hedging Techniques

Advance Hedging Strategies

Sophisticated Hedging techniques are other techniques that are more complicated than the basic ones and are more effective depending on specific market conditions or for the targeted investment objective.

One of them is the Iron Condor strategy where one sells a call and a put at two different strike prices while at the same time, buying a call and a put at two different higher strike prices. If the stock price continues in this range, this strategy works well since it limits gains and losses while offering a chance to profit under typical circumstances.

The Straddle strategy is the next one, and it entails purchasing a call and a put option with the same strike price and expiration date. This is suitable, especially in situations where price fluctuation is expected to be large in either direction since profit can be earned from either direction.

A Strangle is similar to a Straddle but it is costlier than it but is cheaper than it to initiate; it involves purchasing a call option combined with a put option but at different strike prices and a more pronounced price change is required to make profits.

The collar strategy is employed when you have a particular stock, which you wish to hedge by selling a put option while at the same time selling a call option to help generate some form of income. This strategy helps to minimize the potential losses and, at the same time, has limitations of the potential profit, offering a favourable risk/return ratio.

The Butterfly spread is used to build a profit and a loss chart in the form of a butterfly, which gives us an idea of buying a CE or PE option, which has 3 different strike prices but same expiry date. The best outcome for this technique is when the price of the share closes to the middle value of the strike price as this is when there is less fluctuation in price and maximum profits and losses. With the help of these derivative investing methods, risk could be managed and altered as per the change of the market situations and trends to optimize the investment and make it more accurate.

Common Mistakes to avoid while Hedging

As for hedging, it makes sense to avoid common mistakes, since it will significantly affect the effectiveness of risk management. undefined

Over-Hedging: The first error is over-hedging, when investors apply too many hedging tools or techniques. This can lead to a situation of having lots of expenses and reducing the possible profits you can make. Essentially, it is necessary to weigh the risks that a hedge will mitigate against the expense of the hedge to determine whether the hedge is profitable and whether its protection is countering incurring too many losses or giving up too much potential return.

Under-Hedging: On the other hand, under-hedging is when one employs minimal hedging techniques or tools to manage the identified risks. This position makes you vulnerable to increased possible loss. Ensure that you have adequate coverage to protect you against the risks that you’ve identified.

Ignoring the Costs: As with any hedging, there are always costs such as premiums on options or a fee for the transaction. Neglecting these actual costs can exclude you from showing maximum profits. Hedging costs should always be taken into account and weighed against the benefits of each strategy.

Neglecting Market Conditions: Financial hedges should be a reflection of the existing market situation. Unsuitable or old strategies for the present market environment can mean poor hedging. Be aware of what is going on in the market and look for any opportunities to shift your strategies.

Misunderstanding the Hedge: It is very important that you take the time to really comprehend how your selected hedging technique operates. Failing to understand how it works or worse, what could go wrong can have adverse effects. It is also important to spend time to understand the logic of such strategy and the potential threats it can help to avoid.

Not Reviewing and Adjusting: Every market has its unique characteristics, and therefore, your hedging strategies should also be fluid. If a company does not make periodic examinations of its hedging strategies and modify them to reflect changes in either the overall market or in their strategic objectives, then it will not be able to achieve optimum protection. Reviewing your hedging strategy from time to time to see whether is it relevant or not.

Avoiding these common missteps will allow you to apply hedging techniques in a more careful and rational manner to minimize your losses while investing.

Tools and Resources for Hedging

The choice of tools and resources that can be used for effective hedging is also important.

Brokerage firms such as Upstox, Zerodha and Grow offer the range of various instruments, including options and futures, that enable real-time data, analysis, and trading capabilities.

Models for options including the Black-Scholes Model and the Binomial Model assist in understanding the theoretical prices of options for the purpose of their review with regards to pricing and hedging. Both risk management applications, such as Riskalyze for risk profiling and Portfolio Visualizer for generating risk reports and tracking risks, provide insights and recommendations into the best ways to address portfolio risks.

Services such as Bloomberg, Reuters and CNBC aid in understanding the current financial market situation and hence enables one make necessary changes in hedging strategies. Free educational websites like Investopedia, Coursera, and Khan Academy contain valuable information concerning hedging techniques, instruments, and markets.

Furthermore, seeking advice from Certified Financial Planners (CFPs) or any other financial advisors or analysts can prove fruitful as they offer guidance with consideration to one’s specific goals and requirements. VaR calculators and stress testing software are used for the valuation of risks that an investor faces and to assess the performance of investments under certain conditions. With the help of these tools and sources, you will be able to improve your hedging and risk management and make more rational investment decisions.

Conclusion: Hedging in Option Trading

A working method for hedging your portfolio against unexpected market condition is through option trading. Long term put options can be used to make profits by selling the put and lowering the risk exposure.

In this blog, we have provided information “What is Hedging in Option Trading , What is Option Trading, Importance of Risk Management, Overview of Hedging, Purpose of Hedging, What is Hedging in Option Trading with example, Basic Hedging Strategies, Advance Hedging Strategies, Common Mistakes to avoid while hedging “

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