Understanding What Is Hedging In Option Trading: Options trading as a derivative instrument was introduced to protect the interest of the farmers. This was a form of protection tool which would safeguard the interest of the parties involved.

Say, if a farmer produces a wheat crop that is due for harvesting after 2 months. But he is fearful of the fact that when his crop would be ready, then he might not get the desired price and it might be considerably lower than what he wants to sell it for.

And similarly, the Agricultural produce buyer might be fearful that when he is to buy the crop, the price of the crop might be considerably higher than what he wishes to pay. 

So, to protect the interest of both the farmer and the buyer, Options were introduced as a hedging instrument. Here, the price of the produce (agriculture) to be bought or sold was prefixed.

So the farmer would not have to worry about the price he would be receiving and even the buyer of the produce (crop) would also not have to worry about the price fluctuations. So, the earliest use of Options contracts was for the purpose of hedging.

So, let’s get started with the article to learn more about What Is Hedging In Option Trading.

What Is Hedging In Option Trading?

In the world of Finance, Hedging is a simple procedure via which the individual/firms mitigate their risk on their existing position in the market.

One could do this either by formulating a strategy around it to protect against potential downside or by taking an opposite position in the Derivatives (F&O) Market. We will delve into it in the due course while understanding this article.

Quick Read: Options Trading Vs Intraday Trading – Which is Better?

To Define Options

Options are Derivatives Instruments that derive their value from the value of the Underlying Asset. The instrument holder has the right to buy/sell the underlying asset at an agreed-upon price on Expiry.

And the seller of the instrument is obligated to honour the agreement. The Buyer has the right because he pays a premium to the seller and the seller is obligate because he receives the premium upfront. 

Use of Options in the Stock Market

The earliest use of Options in the stock market was generally for the purpose of hedging. The buyers of the stock would want to protect themselves from unforeseen price fluctuations and also to protect the profits made on stocks/securities bought by them.

It is only a recent phenomenon that Options as a trading instrument are used for the purpose of speculative trading. 

Even the best (Investors, Traders, Hedge Funds, etc) use Options in various forms to protect themselves from the downside risk and also improve the entry price of their Investments.

The Ace Investor, Warren Buffets’s company Berkshire Hathway Use ‘Selling Naked Put Options’ as a way of Improving the entry price for the asset that they are invested into. Warren Buffet is of the view that “One should be fearful of the Traders, when they are greedy and Be greedy when they are fearful”.

He believes that traders sometimes give undue weightage to the bearish momentum and that provides an opportunity to get higher premiums for deep Out of Money options by Selling/Writing them. The sellers can take advantage of that and pocket the hefty Premium. 

Now, having understood the basic premise of Options as a Hedging Instrument, let us understand how can one use Options for the purpose of Hedging.

Various Strategies of using Options as Hedging Instruments

There are various means and ways via which a trader can hedge his/her position using options. We will try and understand all the scenarios with the help of an example:

Let’s say that you have bought shares of ICICI bank and you have a bullish outlook on the same in the future. The buying price per share is Rs. 850 and it is trading right now at Rs. 880 per share.

But there have been some rate announcements coming from RBI and that might have a negative impact on all the Banking stocks and ICICI bank being the leading player in the banking sector, would be one the first ones to be impacted because of that. 

Now we will try and understand, how could one hedge using options in his existing position in ICICI bank. 

1. Hedge Using Covered Call

This is a simple strategy that is being used by the traders when they are expecting downside movement in the shares in the shares of the company that they are holding. So under this strategy, you write/sell an Out of Money Call option and Pocket the premium.  

The Objective here is to better or improve the entry price or even if the option expires in the money for the Option buyer, then you would make money on the shares bought in the cash market plus the Premium received for writing. Let us understand with the help of this example. 

In the Initial part of this Article, we bought shares of ICICI Bank at Rs. 850  and it was trading in our favour at Rs. 880 but because of the announcement of an interest rate increase by RBI, the share prices are expected to be negatively impacted. So to hedge ourselves, we write an Out of Money Call option.

Call Option sold: 900 Ce

Premium Received = 20 units (Say)

Days left to Monthly expiry = 7 days

Now, there are two scenarios possible upon expiry. 

If the share price of ICICI bank falls to say Rs. 860, then

  • The Call Option sold will expire worthless for the Option Buyer and the premium received would be income for us.
  • So, net income on Option sold = 20 units
  • The initial entry price on ICIC bank improves by 20 units and the new entry price of ICICI bank for us would be = 850-20 units = 830 units.

Or, If the share price of ICICI Bank goes up and expires at say Rs. 925, then

  • The Option sold would be exercised by the Option Buyer.
  • The loss made on the Option Sold will be = 925 – 900 – 20 = 5 units (loss)
  • The Profit on the shares of ICICI bank bought at Rs. 850 will be

= Rs. 925 – 850

= Rs. 75 per share

So, it can be easily deduced from the above scenarios that the Covered Call strategy potentially protects us from the downside risk when the market comes us and if the markets were to go up also, then we could lose money on the Option sold but the initial position of buy (for which the hedge of Covered call was taken) makes money and our initial bullish views stay intact. 

2. Hedge using Married Put Strategy

This is a very simple and classic strategy that is being used by both traders and investors if they are looking to hedge their existing position. Here in this strategy the trader/investor has a bullish bias on the market but there could be some news or events in the market that could impact their holding in a negative way.

So, to protect themselves, under this strategy they buy Put Options With an equal number of shares. So, if the market drifts on either side, then the trader stands to gain.

Let us Understand the implementation of this strategy by continuing our example of ICICI bank:

ICICI bank share purchase Price: 850

Current Price: 880

Put Option Bought (implement Married Put strategy) = 870 pe by paying a premium of 10 units

If the share price of ICICI bank falls to say Rs. 830, then

  • The Put Option bought will be expiring In the money.
  • Profit on Put Option Bought = 870 – 830 – 10

= 30 units

  • Loss on the existing shares of ICICI bank shares bought in the Cash market 

= 830-850 = Rs. 20

  • So, overall profit when the market comes down to 830 = 30-20 = Rs. 10/share
  • So, it can be deduced that the Married strategy works as a protective shield even when the market drifts massively on the downside.

If the share price of ICICI bank falls to say Rs. 850, then

  • The Put Option bought will be expiring In the money.
  • Profit on Put Option Bought = 870 – 850 – 10

= 10 units

  • Loss on the existing shares of ICICI bank shares bought in the Cash market 

= 850-850 = Rs. 0

  • So, overall profit when the market comes down to 830 = 10/share          

Now, say If the share price of ICICI bank goes up and is at Rs. 900 at expiry, then

  • The Put Option bought will be expiring Out of money.
  • Loss on Put Option Bought = 10 units (Premium Paid will be loss)
  • Profit on the existing shares of ICICI bank shares bought in the Cash market 

= 900-850 = Rs. 50

So, overall profit when the market goes up to 900 = 50-10 = Rs. 40 per share

From the various scenarios above, it can safely be deduced that the Married put strategy is very useful when one is looking to hedge using Options. This works even better when the market suddenly drifts on the downside.

And just in case bullish momentum stays intact, the cash position will make money and the only loss here will be to the tune of Premium paid to buy the Put Option. 

3. Hedge By Buying Put Options Throughout

Now the implementation of this strategy for the purpose of Hedging using Options requires thorough research on the stock for which the strategy is to be employed.

Let us run through the checklist of factors:

  • First, we need to see the seasonality of the stock under consideration. If the stock is bullish for 5 months (say) and bearish for 7 months, then we will have to try and hedge it by buying Put options for those 7 months. Note here, that this strategy is implemented based on the historical movement of the stock prices. 
  • Having understood the likely movement, we will continue with our example of ICICI bank. Let us assume that ICICI banks stay bullish for 7 months and have bearish momentum for 5 months. Then we would be buying Put Options for those 5 months and covering ourselves for the downside risk. 
  • Say we go slightly out of Money Put options and the premium we pay is 1% of the total cost of buying shares of ICICI bank. Then in that case ICICI bank needs to move a minimum of 5% every year in our favour to cover the cost incurred to buy the Put options. 
  • The cost incurred might sound a lot, but it covers you against a potential reversal in the market and also has the chance of making money on the Put options bought.

Also Read: Option Trading Strategies For Beginners

In Closing

From the discussion above it can be seen that Options has a hedging instrument that has a lot of potential of covering us against the downside risk and also potentially make some money if the market comes down.

But one needs to be also aware of the risk associated like the premium being lost or the sometimes upside potential being capped. But if you are looking for a long-term and viable trading strategy then Options have a lot of potential of Protecting your downside.

So that brings us to the end of our article on “What Is Hedging In Option Trading,” which we hope you enjoyed. Please submit your thoughts in the comments section below.

Happy Trading and Money Making!

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