by Ian Harvey
Hedging with options is a strategy that can be used like insurance for your longer term investments in shares. Just like you would buy insurance for your home to limit potential losses that may come from a flood or fire, you can use options to limit the possible loss your investments may suffer from a market downturn. Buying options is essentially betting against your major investments, so that if they suffer a loss, the options you have purchased will gain in value, or allow you to sell the shares at a higher-than-market-price, helping to offset the loss the shares have incurred.
Hedging with options is generally not a strategy that will generate profit, but rather a technique for minimizing possible losses. It is important to remember too, that reducing risk comes at a cost. Like with any insurance, buying options means paying a premium. By hedging with options, you will minimize your potential losses, but you will also reduce your possible gains. If the investment you are protecting by hedging makes money, you will have reduced your gain by the loss of value of the options, which will decrease in value proportionately to the increase of the stock. However, if the investment loses money, you can cover part of this loss with the increase in value of the options you have bought.
A common strategy for hedging with options is to buy put options . Put options give the investor the right, but not the obligation to sell a certain number of shares at an agreed price, known as the strike price.
If you have 100 shares that are currently valued at $25.00, and you have concerns about a possible drop in the price, you may decide to buy put options for those shares, with a strike price of $23.00. If this option contract was valued at $1.10 per unit, you would be paying a premium of $110.00 for the 100 units to hedge your shares (which at that time have a value of $2500.00).
If the share price then dropped to $20.00, you might decide to exercise your options, and sell your shares at the strike price of $2300.00 even though the market value at that time is only $2000.00. By conducting this trade, you will have reduced the potential loss incurred by $300.00 minus the cost of the options premium of $110.00.
If you believe that the shares will regain their value, you may then choose to buy back the same shares you have just sold for $2300.00, at their market value of $2000.00. This can provide the opportunity to recoup the loss of $200.00 between the high point the stock reached and the strike price you sold the shares at, and also the cost of the premium you paid for hedging with options.
The other way that you can use your put options to offset the loss your shares have incurred, is to sell the options at an increased price. If the price of the shares has dropped from $25.00 to $20.00, the options could have made an estimated increase from $1.10 to $1.50. If you sell these options for $150.00, you will have made an increase on the premium you paid for them, but this is fairly small compared to the loss that your shares have currently suffered. However, if you believe that the shares will regain their value, and you don’t want to take the increased risk of selling them and buying them back at a lower price, recouping a smaller percentage from selling your options may be the strategy you feel most comfortable with.
While hedging is not the most exciting, or profit generating use of options, it can be a very important way to protect your investments from suffering heavy losses in the event of price drops. Hedging with options is just one way that trading options can benefit an investor, and wisely executed, hedging can be an effective risk management strategy.
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