Understanding Hedging with Options

What is Hedging?

In finance, a hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. Hedging is a risk management technique for mitigating price risks. It is a way to protect against a price change in a particular market.

In simple language, a hedge is being used to reduce the risk of adverse price movements. In other words, hedging is the simultaneous purchase and sale (or “back-to-back” transaction) of an asset to offset or reduce the risk of another asset.

For example, you might hedge your exposure to the stock market by buying put options on S&P futures. Or, in foreign exchange markets, a hedge is a position that limits a loss from a change in the value of one currency against another. In commodity markets, a hedge is a technique used by a treasury to reduce the risk of a price change on a commodity. In financial markets, a hedge is a position that will offset any potential losses from a portfolio of assets.

Hedging is a risk management technique that is used both by individuals and corporations. In a corporation, departments that are exposed to risks, such as shipping or purchasing, use hedges to manage their risks.

How can I use options to hedge my underlying assets?

Trading options is a technique that allows you to hedge a stock portfolio. If the price of your stock drops, you can exercise your option to buy the stock at the lower exercise price, then sell it in the market at the current price. In the event that the price of your stock rises, you can simply sell the option for a profit.

Hedging is simply reducing or eliminating your risk. For example, if you own a lot of Apple stock you might want to hedge your risk in case Apple’s stock price drops. In this case, you could buy some put options on Apple’s stock. This would allow you to make a profit if Apple’s stock price drops. So when the stock price drops sharply, you can exercise the put option for a guaranteed fixed price. Additionally, you could use the profits to buy Apple at a lower price, which means you have the potential to make a profit. 

Options are very sophisticated financial products which are a form of derivatives. They are commonly used to hedge the risk involved in highly leveraged investments. Hence, options are very useful to minimize the risk of the highly volatile stock market.

If you have a stock portfolio, you should consider hedging it against a decline in value. A stock option is a contract that gives you the right to buy or sell a stock at a specified price for a specified period of time. 

Popular Hedging Strategies

Let’s discuss how to hedge with options by looking at some of the most frequently used hedging strategies.

The Covered Call and the Protective Put

Defensive positions are those which are intended to reduce risk in an underlying stock position. Examples of defensive positions by hedging risk include the covered call and the protective put.

• The covered call position involves purchasing an out-of-the-money call option with the purpose of selling the underlying when it reaches the strike price. A covered call is a strategy that involves selling call options against a stock you own. The option premium is the profit you make from the trade, and you make that profit when the option you sold expires. The only way you can lose money from this trade is in the unlikely event that the stock goes up beyond your strike price when your option expires. If that happens, you have to deliver the stock to option buyer at the strike price.
• The protective put entails purchasing the underlying at the same time that a put option is bought, which will allow the trader to profit if the underlying declines in price. You can also buy puts against your stock. This is a strategy similar to covered call, except that you are willing to take a loss if the stock declines beyond a certain level. This strategy is more complicated than the covered call, and the loss you might incur from the trade is greater, but the profitability of the trade is also greater too.

The Collar

A collar is the most popular out of all options strategies for protecting your portfolios value from market drops, but they also limit potential losses and gains. This strategy involves using two options. The investor collects money by selling the call and pays cash to buy the put. This strategy minimizes losses while not adding any additional out-of-pocket expenses.

In most cases, collars are the go-to choice for investors looking to lock in a fixed rate of return on their investments. However, the limited downside protection makes it so you don’t stand to gain as much as possible if the value of your investments increase beyond a certain point.

Collars are introduced to protect your investment in case the market goes south. They give you a sense of security for when things get rough, and that’s why they’re so popular among investors. This is especially true if the rest of your portfolio is extremely sensitive to changes in market condition such as major swings in performance, both up and down.

Pros and Cons of using collars:

The collar is a good way to mitigate the downside (caused by a fall in price) and upside (caused by a rise in price) risks. A collar is suitable for one who is neutral on the stock.

Since buying a put is expensive, therefore, profits are capped. The potential loss is limited to the premiums paid for the put and call options. The risk of the put is limited to the premium paid for the put option. The potential profit is unlimited. The call option provides you with unlimited profit potential, but the risk is limited to the premiums paid for the put and call options.

How to find the right options for your hedge

Choosing the strike price

• Hedging with Put Options: Choosing the right strike price is a critical aspect. There are different strike prices available for options. If you go with the higher strike prices, then the cost of the put options will be higher. However, if you choose lower strike prices, then the option can expire worthless. So choosing the option strike price that completely fits your needs regarding the estimated downside risk and implied volatility is an important decision that should be done wisely.
• Hedging with Call options: If you want to buy a hedging option as a protection from a short position, then you should go with the option strike price equal to the underlying asset price. If you have a call option on a stock and the stock price goes up, then your call option will increase in value. 

Choosing the right expiry date

It is important to select the right expiry date for your option hedge. It all depends on your outlook for the prices of the underlying. Where do you expect it to be in 1, 3, or 6 months and how much is the intrinsic value of the option on the other hand? That’s the most important question you need to answer.

You want to choose an option with the right time to expiration to accurately hedge your position. Failure to do so may lead to unwanted results or sudden loss of your hedged position (naked position). On the other hand, you don’t want to pay too much for extra time value.

Immediately when you buy an option, the option will start decaying or “expiring” from the day you buy it. So the longer you hold the option, the higher the expiry price will be.

Generally, the longer the time to expiry, the higher the price you pay (and the lower the price you get). If your underlying is less volatile and you’d like to hedge against the bigger losses, then you should always choose the longer expiry date.

On the other hand, if you’re expecting your underlying asset to go up soon, then you’d like to hedge against the smaller losses, and you should choose the shorter expiry date.

Pros and Cons of Hedging with Options

Advantages of Hedging with Options

• Fast way to decrease risk: Hedging stock portfolios with options is a practice that helps decrease risk. This is because it helps to protect the value of your portfolio by increasing your potential earnings. Hedging also allows you to transfer the risk away from the individual who is holding the stocks in the portfolio. The individual can now focus on other aspects of their business.
• Low trading costs: The second advantage of using options for hedging is that options have a relatively low “trading cost.” That means you can enter or exit a trade with minimal impact on the cost of the trade.
• Easy to understand: The third advantage of hedging with options is that they are easy to understand. If you are new to investing, it may take you longer to understand the stock market than it will to understand an option hedge strategy. If you already understand the stock market, hedging stocks with options will probably seem simple to you.

Disadvantages of Hedging with Options

• Cost of monitoring: The main disadvantage of hedging with options is the cost of monitoring the option market. It can be much more complex to carry out than a simple portfolio hedge. While a portfolio hedge simply involves a long position in a hedge fund that is inversely correlated to a portfolio, a hedged portfolio with options will require a hedger to monitor the market price of an option in order to adjust the hedge in a timely manner.
• Risk of losing money: The second disadvantage of hedging with options is that it is possible for a trader to lose money when hedging with them. This can occur if the underlying stock has a significant increase in price before the expiration date of the option. If this happens, the investor will have to pay the difference between the market price of the stock on the expiration date and the strike price of the option. In fact, it is possible that a trader who is only partially familiar with the stock he is hedging may not realize that the hedge is not properly aligned until after the expiration date of the option. By then, it may be too late to adjust the hedge without incurring substantial additional costs.

What assets can you hedge with options?

In general, the more valuable the asset, the more likely it is you will need to consider hedging it with derivatives. Here are some examples of assets you might want to consider hedging:

• Stocks – Stocks are the most common asset you will want to hedge because they are easy to understand and easy to value. The first thing you should do if you want to hedge a stock position is to determine how much of the stock price is “attributable” to the underlying company. For differences between stocks and options read our comparison of stocks and options.
• Indices – Hedging Index positions with options is a popular strategy among institutional investors. Like stocks, indices are relatively easy to understand and easy to value. However, unlike stocks, there are many different indices to choose from. So, before you decide to go this route, you should make sure the index you are considering hedging is one which makes sense to hedge. For example, if you are long the Standard & Poor’s 500 Stock Index, you should not also go short the Dow Jones Transportation Average. Also, just because an index has a certain attribute (e.g., it is an “S&P 500 Index Option”), it does not mean you can use that index for your option hedges. Many S&P 500 Index option contracts have no relationship to the actual S&P 500 Index at all.
• Bonds – Like stocks, bonds prices are relatively easy to follow. However, unlike stocks, there are very few different types of bonds to choose from. That means, if you are long bonds, you should be aware there may be certain types of bonds which are easier or more difficult to hedge than others. For example, government-issued bonds are usually considered “safe” or “risk-free” because their creditworthiness is backed by a sovereign government. That makes them almost as good as cash. In contrast, corporate bonds are considered “risky” because they are issued by companies with less than “perfect” credit. By the way, the price of corporate bonds is going to be very volatile until the company’s future earnings are projected for that particular bond. Also, corporate bonds have an “in-the-money” or “ITM” component. This means if you are long a certain type of bond (e.g., a corporate bond) and the price of that bond goes up in price, there will be a corresponding increase in the “intrinsic” or “net” value of your position.
• Commodities – Commodities are tricky because they are so diverse. However, you can usually classify them as either physical or financial. Physical commodities are things like gold, oil, silver and the like. Financial commodities are things like interest rates, exchange rates and indexes such as the S&P 500 Index. The first step you should take if you want to hedge a financial commodity is to determine which of the indexes or rates you think will affect your asset the most. After you have identified the commodity you want to hedge, the next step is to identify which of the indexes or rates you want to use as a hedge. Here are three ways you can go about doing this: Hedge with an Index – If you believe one or more of the indexes or rates you are considering using as a hedge will move in the same direction as your asset, what you do is buy an option on that index or rate.
• Currencies – If you invest in any of these types of investments, you should consider hedging at least part of your investment with fx options. This is especially true if your investment has a significant element of risk or you intend to sell your investment quickly.
• ETFs and Mutual Funds – ETFs and mutual funds are a great way to invest in stocks and other assets. However, they are even more tax-efficient than stocks if you invest through an IRA or other retirement account. You should still consider hedging your mutual fund and ETF positions with options but not to the same extent you would consider hedging a stock position. 

… and More! There’s no limit to the number of asset classes you can use for your option hedges. And remember… The Options Hedging Spectrum Is Vastly Underappreciated! One final thought on this subject:

All of the above can be hedged with options, but which ones you should hedge depends on your own risk tolerance and goals.

Using Stop loss vs hedging the position with options

The difference

Hedging with options is a more advanced trading strategy than simply using a stop loss. A stop loss simply tells you when to get out of your position. It is a good strategy for new traders, but it’s quite easy to get fooled by price action and lose money.

A stop loss helps you limit your losses when the markets turn against you. The problem is, the further away your stop is located, the more you lose in the process. With options, you get to choose your risk management level before the markets turn against you.

For example, if the price of the underlying has dropped considerably, you can get back into your position and sell your options for a higher price than you bought them for. A stop loss would not have allowed you to do this. This is why hedging with options is a better strategy than simply using a stop loss.

When you use a stop loss, you lose the difference between values of your entry and your stop loss. So when you use a stop loss, you keep the same position if the market moves against you. However, when you use an option as a hedging technique, you can limit your losses. A stop loss helps you limit your losses when the markets turn against you.

Problems with Stop Losses

The problem is, the further away your stop is located, the more you lose in the process. Also, in a volatile market like we’ve been in for the past few years, the price of the underlying instrument may well change in the process of reaching the stop loss.

With options, you get to choose your risk management level. If you have a large amount of cash tied up in your position, you may choose the riskier approach of using a stop loss. If you have minimal cash tied up in your position, then you can choose a larger margin of safety by selecting an option hedge. This is a great tool for traders who have a smaller account.

Hedging with options vs holding cash

Hedging when done correctly leads to a neutralized position on the underlying asset, at least in theory. It simply means that you sell and buy the same amount and this way you eliminate one side of the risk.

So what is the advantage of opening a hedge vs selling the underlying asset?

The answer is simple: You still make money on the open position even if the market moves against you! The main advantage of hedging is that it allows you to sleep better at night because you do not have to be glued to your computer screen watching every single tick of the market. Also, by eliminating one side of the risk, you increase your odds of making a profit, especially when the market is moving against you.

Key Takeaways – Hedging with Options

Hedging risk with options is not for the faint of heart. It’s a complex subject and, if you’re not careful, it can ruin your portfolio. However, if you understand what you are doing it can be one of the best things you can do for your portfolio.

• You can’t completely eliminate risk but it’s possible to decrease it dramatically by hedging with options, creating a buffer zone and limiting losses as you move forward through this endeavor.
• If one position declines in value, options that offset the trade will hopefully turn a profit – balancing out the risk and creating a positive outcome.
• Hedging strategies include the covered call, the protected put, and the collar.
• You can hedge shares, forex, indices, commodities, and others with options.