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.