HOW DOES HEDGING WITH OPTIONS WORK?

Hedging with options involves opening a position – or multiple positions – that will offset risk to an existing trade. This could be an existing options position, another derivative trade or an investment.

While hedging strategies can’t entirely remove all your risk – as creating a complete net-zero effect is nearly impossible – they can limit your risk to a known amount. The theory of hedging is that while one position declines in value, the other position (or positions) would make a profit – creating a net zero effect, or even a net profit.

As options are complex instruments, it’s important to understand exactly how they work before you start hedging.

Options explained

Options are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset once its price reaches a certain level – known as the strike price – at or before an expiry date.

An option only has value once the strike price has been met – known as an at-the-money option – or surpassed – known as an in-the-money option. Prior to this, the option has no intrinsic value, so is out of the money.

There are two types of options available to you:

1.       Call options – these give the holder the right, but not the obligation, to buy an asset. You’d buy a call option if you believe the market price will rise from its current level, and you’d sell a call option if you think it will fall

2.      Put options – these give the holder the right, but not the obligation, to sell an asset. You’d buy a put option if you believe the market price will fall from its current level, and you’d sell a put option if you think it will rise

It’s important to remember that your risk is always limited when you’re buying call or put options, but potentially unlimited when selling them.

Learn more about what options are and how you can trade them

Put options are more commonly used in hedging strategies, as opening a position to sell the same asset you currently own can help prevent downside risk. However, if you have a short position open, call options strategies would have the same logic behind them – you’d open the opposing position, going long to offset risk.

When hedging using options, you’ll need to consider how much the premium of the trade is. If the cost of opening the position is going to eradicate any of the returns you could make on your hedge, then it’s not worth doing. However, if you could pay the premium and still have a net balance of zero – or even generate a profit – then it’s a strategy worth considering.

What assets can you hedge with options and why?

As long as an options market is available, you can create an options hedge. With us, you can hedge with options on:

·         Shares

·         Indices

Hedging equities portfolio with share options

Using options to hedge against risk to an equity portfolio is an extremely popular strategy. While investors aren’t typically concerned with shorter-term movements, hedging can create additional profit or reduce short-term risk. Plus, you’d be doing so without having to sell your shareholdings, potentially losing out on longer-term profits.

While most hedges involve opening a position in a non-correlated market, when you hedge with derivatives, you can open a short position on the same asset you hold.

Traditional short-selling is a complex method, but both a long put or short call enable you to take a position on declining markets. This would create a hedge if you believe the value of a stock you own is going to fall significantly before the option’s expiry. However, long puts tend to be the more popular means of shorting with options, as your risk is limited.

You can hedge with shares on the FTSE 100, DOW 30, the S&P 500, the Nasdaq 100 and Euronext 100¹ – as long as there is a tradable options market on the underlying. When you trade options via CFDs and spread bets, you’ll get exposure to options prices without having to enter the options contract yourself.

Learn more about share trading

Example of an equity options hedge

Say you own 1000 shares of Reliance that are currently trading at 100p each – giving you a total exposure of 1000. You believe that a news announcement is going to cause the market price to fall during the week, so you decide to buy a put option on Reliance shares via CFDs. One options CFD is worth the equivalent of 1000 shares of the underlying.

You choose a strike price of 95, which means that Reliance shares have to fall below 95p before the option is in profit. To open your position, you’d pay a premium of 25 and 10 commission.

Let’s say the price of Reliance did fall to 90p – your shareholding would have made a loss of 100 (1000 – 900).

However, your put option would be in profit by 50 ([95 - 90] x 1000) – giving you a total profit of 15, once you’d removed the costs you’d paid to open the position.

Overall, your hedge would’ve reduced your total loss from 100 down to 85.

Hedging with index options

To manage a large stock portfolio, it can be more efficient to hedge using an index rather than opening multiple positions to hedge each share you own. All you’d need to do is ensure that the index matches the composition of your portfolio in terms of sectors and weighting.

You might also have an exchange-traded fund (ETF) index position, which gives you exposure to an entire index without having to buy individual shares. This means that hedging with the corresponding index option is a great way to get one-for-one exposure to your current position.

Example of an index option hedge

You believe that the UK economy will experience a long-term decline, leading the FTSE 100 to fall in value. So, you’ve got a spread bet position on the index to fall from its current value of 5800. Your spread bet is for 10 per point of movement, giving you an exposure of 58,000 (10x5800) for just 5800 – due to the 10% margin on spread bets.

Learn more about spread betting.

However, an upcoming government announcement is expected to cause a short-term rally on the index. Instead of closing your short-trade and reopening it, you decide to use a daily index call option to hedge the rising prices.

You open a spread bet for 100 per point of movement on an option with a strike price of 5880 – with a premium of 4 points. This would give you a total exposure of 400 (4 x 100).

The price of the index does rise, up to 5900. Your short spread bet would have lost you 1000 ([5900 – 5800] x 10). However, your option is in the money by 20 points, giving you a total of 2000. Once you subtract the premium, you’d have a profit of 1600 on your option.

Your hedge would’ve balanced out the loss to your spread bet, and you’d be in profit by 600. Your short index position would still be ready if the market declines as you’re expecting.

If the index had fallen in value instead, you would have lost the 400 premium but would have made profit on your spread bet that could be used to offset this.

·         Hedging with options involves opening an options position – or multiple positions – that will offset any risk to an existing trade

·         If one position declines in value, the other position (or positions) would hopefully turn a profit – balancing each other out or even creating a net profit

·         Hedging strategies can’t entirely remove all your risk, but they can help to limit your risk to a known amount

·        Your decision about when to hedge using options will largely be based on how much the premium of the trade is. If the cost of opening the position is more than the potential profit, it might not be worth doing

·       Long puts tend to be more popular means of hedging as your risk is limited.

·        You can use options to hedge shares, indices.