Options trading can be a potentially lucrative investment activity, but it comes with inherent risks. To mitigate potential losses and manage risk in their investment portfolio, investors often use a technique called hedging. In this article, we aim to explore what options trading is, how traders hedge to minimize risks, and finally, offer some strategies when hedging with options.
If you are keen to start trading options right away, you can do so with a reputable broker such as Saxo.
What is options trading?
Before diving into hedging, we should deconstruct options trading. Essentially, options trading is a type of investment strategy that involves buying and selling options contracts. An option is a financial derivative that gives the buyer the right, but not the obligation, to buy or sell an underlying asset (such as a stock, commodity, or currency) at a specified price within a certain period of time.
Why trade options?
People trade options for many reasons, as its main advantages include:
Potential for high returns
Options trading can offer higher potential returns than other types of investments, such as stocks or bonds. This is because options allow investors to make bets on the future direction of an underlying asset’s price, and if they are correct, they can earn a significant profit.
It is also a versatile investment activity that can be used in a variety of ways. Investors can use options to hedge against potential losses in their portfolio, generate additional income, or take advantage of potential price movements in an underlying asset.
The third main benefit of options trading is that investors can limit their potential losses by purchasing options contracts. Unlike buying shares of a stock, which can result in significant losses if the stock price decreases, options contracts allow investors to control their exposure to risk. If the market does not perform well, traders can simply let their contract expire worthlessly, and they only lose the premium.
Access to a wide variety of markets
Finally, options trading can be a useful tool for diversifying an investment portfolio as traders can participate in a variety of markets, ranging from forex and commodities to stocks and indices. By including options as part of their overall investment strategy, investors can potentially reduce their overall risk and increase their potential for returns.
What is hedging?
Hedging is a strategy used by investors to reduce or offset the risk of potential losses in their investment portfolio. It involves taking an opposite position in another financial instrument that is negatively correlated to the original investment.
Hedging in options trading
In options trading, hedging typically involves buying or selling options contracts to offset the risk of losses in an underlying asset. For example, an investor who owns shares of a stock may buy put options on the same stock to protect against potential losses if the stock price decreases. If the stock price does decrease, the investor can exercise the put options and sell the shares at the strike price, which is higher than the current market price, reducing their potential losses.
Common strategies for hedging in options trading
There are several types of options strategies that can be used for hedging, including:
Protective puts are a type of options strategy that involves buying put options to protect against potential losses in a stock or other underlying asset. In this strategy, an investor who owns shares of a stock buys put options on the same stock. If the stock price decreases, the put options can be exercised, allowing the investor to sell the shares at the strike price, which is higher than the current market price, reducing their potential losses.
Covered calls are a type of options strategy that involves selling call options on a stock or other underlying asset that an investor already owns to generate additional income while offsetting potential losses. In this strategy, an investor who owns shares of a stock sells call options on the same stock. If the stock price increases, the call options can be exercised, allowing the investor to sell the shares at the strike price, which is lower than the current market price, reducing their potential losses.
Collars are a type of options strategy that combines a protective put and a covered call to create a range of prices within which the investor’s profit and loss is limited. In this strategy, an investor who owns shares of a stock buys put options and sells call options on the same stock. The put options protect against potential losses if the stock price decreases, while the call options generate additional income if the stock price increases.
Straddles are a type of options strategy that involves buying both a call and a put option on the same underlying asset at the same strike price and expiration date to take advantage of potential price movements in either direction. This strategy is often used when an investor expects significant price movement in the underlying asset but is unsure which direction it will move.
Spreads are a type of options strategy that combines two or more options contracts of the same type (either calls or puts) to limit potential losses while still allowing for potential gains. In this strategy, an investor buys and sells options contracts at different strike prices and/or expiration dates to create a range of prices within which their profit and loss is limited.
Putting the strategy to test: an example of a hedge
Suppose an investor in the United States has a large investment in a Hong Kong-based company and is concerned about potential currency fluctuations that could negatively impact their investment. To hedge against this risk, the investor could use options trading to protect their investment.
The investor decides to use protective puts. This means they would purchase put options on the Hong Kong dollar, giving them the right to sell the currency at a specified price (the strike price) within a certain time frame (the expiry date).
Let’s say the current exchange rate is 7.75 HKD/USD and the investor purchases put options with a strike price of 7.70 HKD/USD that expires in six months. If the exchange rate were to drop below 7.70 HKD/USD within that time frame, the investor could exercise the put options, selling their Hong Kong dollars at the higher strike price and mitigating their losses.
Certainly, there are costs associated with purchasing put options, including the premium paid for the options contract. However, this strategy allows the investor to limit their potential losses in the event of adverse currency fluctuations while still allowing them to benefit from potential gains if the exchange rate remains favorable.
The bottom line
Hedging in options trading can be a useful strategy for managing risk in an investment portfolio. There are many strategies you can employ when hedging options trades, including the collar, straddle, strangle, protective put, and covered call. However, regardless of which one you choose, it is crucial to remember that there is no strategy that can eliminate risk, and hedging strategies may also limit potential gains. Investors should carefully consider their risk tolerance and investment goals before using hedging strategies in their portfolio.