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.
