How to Hedge With Options: Key Hedging Strategies

Hedging in financial markets involves strategies to reduce potential losses from adverse price movements in an asset or portfolio. Options, which are contracts granting the right but not the obligation to buy or sell an underlying asset, serve as a versatile tool for managing such risks. They allow investors to protect existing investments from market downturns or to lock in favorable prices for future transactions, mitigating uncertainty and safeguarding financial positions.

Key Concepts of Options for Hedging

A “call option” provides the holder the right to purchase an underlying asset at a predetermined price, while a “put option” grants the holder the right to sell an underlying asset at a predetermined price. These rights are valid until a specific “expiration date.”

The “strike price” is the fixed price at which the underlying asset can be bought or sold if the option is exercised. The “premium” is the cost paid by the buyer to the seller for acquiring the option contract itself. This premium represents the maximum loss for the option buyer and the maximum gain for the option seller.

An option’s “moneyness” describes its relationship between the strike price and the current market price of the underlying asset. A call option is “in-the-money” if the underlying asset’s price is above the strike price, “at-the-money” if equal, and “out-of-the-money” if below. Conversely, a put option is in-the-money if the underlying asset’s price is below the strike price, at-the-money if equal, and out-of-the-money if above.

Basic Option Hedging Strategies

Using options for hedging involves combining them with an underlying asset to achieve a specific risk management goal. One common method is the “protective put,” which aims to safeguard an existing stock position from a decline in value. An investor holding shares of a stock purchases a put option on that same stock.

The purpose of a protective put is to set a minimum selling price for the stock, effectively acting as an insurance policy. If the stock price falls below the put option’s strike price, the investor can exercise the put, selling their shares at the higher strike price. This strategy limits potential losses while allowing the investor to benefit if the stock price increases.

For example, owning 100 shares of a stock at $50 and buying a put option with a strike price of $45 means if the stock falls to $40, the investor can still sell shares at $45, limiting the loss to $5 per share plus the premium paid.

Another widely used strategy is the “covered call,” where an investor holding shares of a stock sells a call option against those shares. The term “covered” indicates that the investor owns the underlying shares, which can be delivered if the call option is exercised. The objective of a covered call is to generate income from the premium received from selling the call option.

By selling a call option, the investor agrees to sell shares at the strike price if the option is exercised before expiration. This strategy is used when an investor believes the stock price will remain relatively stable or experience only a modest increase. While it provides income, it also caps the potential upside profit on the stock at the call option’s strike price.

For instance, an investor owning 100 shares of a stock at $50 might sell a call option with a $55 strike price, receiving a premium. If the stock rises above $55, the shares might be called away at $55, but the investor retains the premium income.

Practical Considerations for Hedging

Implementing option hedges requires careful consideration of several practical factors. Selecting the appropriate strike price and expiration date is important, as these choices directly influence the cost and effectiveness of the hedge.

A strike price closer to the current market price or an option with a longer time to expiration will command a higher premium. Investors must balance their risk tolerance and time horizon with these associated costs.

Costs involved in options hedging extend beyond the option premium. Investors also incur typical brokerage fees, which may include a per-contract charge. Small regulatory fees are also usually passed on to the investor. These transaction costs can accumulate, impacting the overall profitability of the hedge.

Monitoring the hedge over time is a continuous process. Market conditions, such as changes in the underlying asset’s price or implied volatility, can significantly affect the option’s value. A hedge that was effective at initiation might become less so as market dynamics evolve. Regular review allows investors to assess if the hedge continues to meet its intended purpose.

Adjusting or closing out a hedging position becomes necessary when market conditions shift significantly or when the original hedging objective has been met or is no longer relevant. This might involve rolling the option to a different strike price or expiration date, or simply closing the entire position by selling the purchased option or buying back the sold option. Active management ensures the hedge remains aligned with the investor’s current risk management goals and helps optimize the trade-off between protection and cost.