Options are versatile financial instruments that can be utilized in different ways. One significant use of options is hedging. Hedging involves offsetting potential losses in an investment by making a counter-investment. This article explores how options can be used for hedging, featuring real-world examples for clarity.
Before we delve into hedging using options, let's quickly review what options are. Options are derivatives, meaning their value is derived from an underlying asset, which can be stocks, ETFs, bonds, commodities, currencies, or other financial instruments. There are two types of options:
Call Options: Give the holder the right (not obligation) to buy the underlying asset at a predetermined price (the strike price) before a certain date (the expiration date).
Put Options: Give the holder the right to sell the underlying asset at the strike price before the expiration date.
The Basics of Hedging
Hedging is a strategy used by investors to offset potential losses from another investment. Essentially, it is a form of insurance. Investors hedge for different reasons. For instance, an investor may hedge to protect profits, reduce the risk of a loss, or to mitigate volatility.
Using Options for Hedging
Options, with their ability to protect against possible adverse price movements, provide a relatively affordable way to hedge investment risk. They are ideal for hedging because they allow an investor to protect an investment against downside risk with a known upfront cost (the premium).
Protective Put Strategy
One common method of hedging with options is the protective put strategy. Here, an investor purchases put options for an underlying asset they already own. In doing so, they set a floor, effectively limiting their downside risk. Example: Let's say you own 100 shares of Company XYZ, currently trading at $100 per share. You're bullish on the long-term prospects of XYZ, but are concerned about short-term volatility. To hedge, you could buy a three-month put option with a strike price of $95 for a premium of $3 per share. Here are possible outcomes:
XYZ falls to $90. Without the put option, you would have a paper loss of $1000 (100 shares * ($100 - $90)). But with the put, you can sell your shares for $95 each, limiting your loss to $500 in share price, plus the $300 premium, totaling $800.
XYZ rises to $110. You profit $1000 from the share price increase (100 * ($110 - $100)), but lose the $300 premium paid for the put. Your net profit is $700.
Through this example, we can see how the protective put strategy can limit downside risk while allowing participation in any upside potential.
Covered Call Strategy
Another popular hedging strategy with options is the covered call. In this strategy, an investor sells (or "writes") call options on an asset they already own. This approach generates income (the premium) and provides some protection against a slight drop in the underlying asset's price. However, the investor also gives up potential profits if the asset's price significantly increases. Example: You own 100 shares of XYZ, trading at $50 per share. You write a one-month call option with a strike price of $52 for a premium of $2 per share. Possible outcomes:
XYZ falls to $48. Your shares lost $200 in value (100 * ($50 - $48)), but you earned $200 from the premium. Therefore, your net loss is zero.
XYZ rises to $55. You're obligated to sell your shares for $52 each, missing out on the extra profit. However, your profit is $400 from the increase in the share price (100 * ($52 - $50)) plus the $200 premium, totalling $600.
Thus, a covered call can help mitigate a small decrease in the underlying asset's price, while also generating income. However, it limits the profit potential if the asset's price substantially increases.
Hedging with options allows investors to limit risk while maintaining the potential for profits. It's an advanced strategy that requires a solid understanding of how options work and careful risk management. However, the versatility of options, their potential returns, and their capacity for risk mitigation make them an excellent tool for hedging. Before engaging in options trading, ensure you thoroughly understand the instruments and strategies involved and consider seeking advice from a financial advisor or broker.