Altering the underlying asset of one’s investment portfolio can be rather stressful and time-consuming, as requires knowledge about the steep market movements and constant vigilance on account of the deep losses that could stem from market uncertainty. Investors, too, need a strategy to ease the burden of such market volatility, and traders have come up with rather convenient options: A purchase may be made on an asset at a given price within an allotted time period, without any obligation whatsoever. In this article, we will provide you with a foolproof strategy on how options contracts can serve as a hedge in your investing endeavors while enabling you to lock in the value of your ownership.
In this article, we will cover the volatility of the markets, and try to bring forth an understanding that will help traders navigate these waters peacefully through the use of options contracts and options trading strategies that provide protection to the holder from aggressive price changes of the underlying asset, leading to guaranteed profits or minimized losses.
Understanding Options
Options contracts give the holder either the right to sell the given asset or the right to buy the asset at a specified point in time at a defined valuation.In this case, we are concerned with only two forms of options contracts which are usually referred to as call options and put options.
Call Options:
These put the holder in a position of power, as they have the option of exercising their right to purchase the underlying asset on or before the expiration date at the predetermined value.
Call options are used when an underlying asset’s value appreciates in the near future from the investor’s perspective.
Put Options:
These give their holder the right, but not the obligation, to sell a given stock at a predetermined price prior to the expiration date. An investor is likely to put options when analyzing the cost of the underlying asset will drop in the future.Key terms associated with options include:
- Strike price: The price at which the underlying asset can be bought or sold.
- Expiration date: The date on which the option contract expires.
- Premium: The price paid by the buyer to the seller for the option contract.
Hedging with Put Options
Buying put options is a common strategy for hedging against a decline in the value of an asset. For instance, if you own shares of a stock and are concerned about a potential price drop, you can purchase put options on that stock. This acts as an insurance policy.
Here’s a simple example: Suppose you own 100 shares of XYZ stock, currently trading at $50 per share. To protect against a potential price drop, you buy a put option with a strike price of $48 and an expiration date three months away. You pay a premium of $2 per share, totaling $200.
If the stock price falls to $45 before the expiration date, you can exercise your put option and sell your shares at $48, limiting your losses. Without the put option, your losses would have been greater. The put option effectively offsets the loss in the stock’s value. However, the cost of this protection is the premium you paid.
Hedging with Call Options
While put options are more commonly used for hedging against falling prices, call options can also be employed to hedge against rising prices, particularly for assets you plan to purchase in the future.
Consider a business that needs to buy a specific commodity, such as oil, in three months. To protect against a potential price increase, the business can buy call options on oil with a strike price close to the current market price. If the price of oil rises, the business can exercise the call option and buy oil at the predetermined strike price, effectively locking in a favorable price. This strategy protects the business from the risk of increased costs.
Beyond simple put and call options, more advanced hedging strategies like collars (combining put and call options) and spreads can be employed to fine-tune risk management.
Final Thoughts
To limit risk, investors manage option purchasing volatility with put and call options. Investors with put options are ready to bear declining asset value while those with call options are protected against increased asset value. It is essential to strike the right balance between risk reduction and cost optimization, bearing in mind that the hedge will come at the cost of a profit-reducing premium charge.
