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Risk Management And Options - Hedging With Options



Risk Management And Options - Hedging With Options

There are two main reasons why an investor would use options: to speculate and to hedge.

Speculation

You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.

Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option, you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and how much the price will change as well as the time frame it will take for all this to happen. And don't forget commissions! The combinations of these factors means the odds are stacked against you.

So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about using leverage. When you are controlling 100 shares with one contract, it doesn't take much of a price movement to generate substantial profits.

Hedging

The other function of options is hedging. Think of this as an insurance policy; just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way.

Hedging is often considered an advanced investing strategy, but the principles of hedging are fairly simple. Read on for a basic grasp of how this strategy works and how it is used. 

Hedging means reducing or controlling risk. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be countered by changes in the value of a futures position. For instance, a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position.

Everyday Hedges

Most people have, whether they know it or not, engaged in hedging. For example, when you take out insurance to minimize the risk that an injury will erase your income or you buy life insurance to support your family in the case of your death, this is a hedge.

You pay money in monthly sums for the coverage provided by an insurance company. Although the textbook definition of hedging is an investment taken out to limit the risk of another investment, insurance is an example of a real-world hedge.

Expansion

Hedging has grown to encompass all areas of finance and business. For example, a corporation may choose to build a factory in another country that it exports its product to in order to hedge against currency risk. An investor can hedge his or her long position with put options or a short seller can hedge a position though call options. Futures contracts and other derivatives can be hedged with synthetic instruments.

Basically, every investment has some form of a hedge. Besides protecting an investor from various types of risk, it is believed that hedging makes the market run more efficiently.

One clear example of this is when an investor purchases put options on a stock to minimize downside risk. Suppose that an investor has 100 shares in a company and that the company's stock has made a strong move from 25 Rs. to 50 Rs. over the last year. The investor still likes the stock and its prospects looking forward but is concerned about the correction that could accompany such a strong move.

Instead of selling the shares, the investor can buy a single put option, which gives him or her the right to sell 100 shares of the company at the exercise price before the expiry date. If the investor buys the put option with an exercise price of 50 Rs. and an expiry day three months in the future, he or she will be able to guarantee a sale price of 50 Rs. no matter what happens to the stock over the next three months. The investor simply pays the option premium, which essentially provides some insurance from downside risk. (To learn more, read Prices Plunging? Buy A Put!)


Hedging, whether in your portfolio, your business or anywhere else, is about decreasing or transferring risk. It is a valid strategy that can help protect your portfolio, home and business from uncertainty. As with any risk/reward tradeoff, hedging results in lower returns than if you "bet the farm" on a volatile investment, but it lowers the risk of losing your hard earn money.