The stock market is a rollercoaster ride. The prices are unpredictable and surprise all of us with huge losses. One of the most effective ways to protect oneself from such risks is through using options to hedge portfolios. The article discusses what options are, how they can be used for hedging purposes, along with practical examples to illustrate the benefits.
Understanding Options Strategy
Options are financial instruments that give the holder an option to right of buying/selling asset on agreed price within decided timeframe but are not obligated to. Call and put options are two types of options with their unique features.
- Call Options: It is an option that provides its buyer the right of acquiring an asset at a specific price.
- Put Options: It is an option that provides its buyer the right of selling an asset at a specific price.
Why Hedge Your Portfolio?
Investors hedge to reduce the risk of an asset caused by adverse price movements. Options help mitigate market volatility of the portfolios. According to research done by the CFA Institute, "the most significant benefit of hedging is significantly reduced portfolio risk, up to 20% on average, while still enabling good upside potential.
How Options Work for Hedging?
Using options for hedging involves strategically buying put or calls to hedge possible losses. Let's see how to use each of them.
- Using Put Options: The most commonly used hedge against a declining market is put options. Let's assume that you have a share in a company that is selling at the price of $50. You anticipate it might begin dropping in price but don't want to sell shares at this juncture. Therefore, to prevent maximum loss in the event of such a downturn, you may get a put option with strike price at $45. If the price of stock drops to $40, your put option lets you sell at $45. You lose just $5 a share instead of $10. Assuming the premium may be $2 a share for this put option, your net loss, here, is really $7 a share.
- Using Call Options: Call options are also used in hedging, especially when you are short on a certain stock. If you have short-sold some shares and you are worried about a sudden increase in the price, a call option can be purchased so as to cover one's position. For example, you short-sell stocks at $50 on hopes that the price may decline. If the stock increases to $60, you would have almost limitless loss. However, if you hold a call option with strike price at $55 with a premium of $3, your loss is capped. If the stock moves to $60, you can exercise the call and cap your loss.
Measurable Tools for Successful Hedging
To understand the implication of hedging with options, consider these metrics:
- Cost of Options: The premium that you pay for options is a key factor. Always assess if the potential protection is worth that cost.
- Rate of Change (Delta): This is a word that denotes the derivative of price of an option relative to the price of the underlying asset. The delta for put options should be -1, that is, as the stock goes up, the option price moves in the opposite direction. This becomes useful hedging.
- Volatility: Increasing volatility increases option premiums. You can know when to hedge when you understand the state of the market. Let's assume that you have a portfolio valued at $100,000. You could hedge if the market dropped by 20% by buying put options on 20% of your portfolio. If the market dropped by 10%, this would cost your portfolio $10,000 as well. However, it may be worth more for the put options reducing some part of those losses. If you buy put options at $2,000 to protect against this, your realized loss in a downturn is $8,000 whereas it would be $10,000 without hedging. That is how one can quantify relatively simply the financial advantages of hedging.
Options Ensemble Optimal Portfolio
Options enable one to hedge any portfolio effectively. As long as you do a proper analysis of your investments and the market situation, you can use puts and calls to safeguard your assets when there are untimely downturns. While options may be intricate, understanding their purpose and how to apply them effectively will significantly enhance your strategy in investing. Hedging through options can be what your portfolio needs to be sure of its stability. Whether you are a young investor or someone who has experienced the scope of time in investing, consider hedging benefits through options to secure your future financial end.
