Option Hedging Strategies: Beginner Guide

Introduction

Did you know that 32 million demat accounts were opened in FY 2024? This growing interest highlights the importance of understanding option hedging strategies. If you're new to investing, especially in options, this guide will help you navigate the complex world of option hedging, making it simple and approachable.

What is an Option

An option is a financial instrument that gives you the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specific date. There are two types of options: call options and put options. A call option allows you to buy the asset at a predetermined price, which is useful if you expect the asset's price to rise. A put option allows you to sell the asset at a predetermined price, which is beneficial if you anticipate a price drop.

In the Indian stock market, people use options for two main reasons: to protect themselves from losing money (hedging) and to try to make money by guessing how prices will change (speculation).

Hedging:

Think of hedging like insurance. If someone owns some stocks and is worried their prices might fall, they can use options to protect themselves. If the stock prices do drop, the options can help cover some of their losses.

Speculation:

Speculation is like making a bet. If someone thinks a stock's price will go up or down, they can use options to try to make money from their prediction. If they are right, they can earn a profit from the changes in stock prices.

Example:

Vijay is an investor who owns shares of ABC Ltd, currently priced at ₹500 each. He is worried that the price might fall, so he buys put options that allow him to sell the shares at ₹480. If the price drops to ₹400, Vijay can still sell his shares at ₹480, protecting himself from a more significant loss.

On the other hand, Sneha believes that the shares of XYZ Ltd, currently priced at ₹300, will rise in the next month. She buys call options that allow her to purchase the shares at ₹320. If the price goes up to ₹400, Sneha can purchase the shares at ₹320 and sell them at ₹400, making a profit of ₹80 per share (minus the cost of the option).

In short, Vijay uses options to hedge and protect his investments from losses, while Sneha uses options to speculate and try to make a profit from expected price increases.

What is Hedging in Option Trading

Hedging is a strategy used to protect your investments from potential losses. In option trading, hedging involves taking an opposite position in the market to offset the risk of price movements. For instance, if you own shares of a company and fear a price drop, you can buy a put option to hedge against this potential loss. Essentially, hedging acts like an insurance policy for your investments.

Example: Rajesh is a Bangalore resident who invests in Indian stocks. He owns 100 shares of ABC Ltd., currently priced at ₹1,400 per share. Rajesh is worried that market volatility will cause the price of these shares to drop in the next few months.

Rajesh decides to hedge his investment by buying a put option to protect himself. A put option gives him the right to sell his shares at a predetermined price, known as the strike price, at any time before the option expires. Rajesh buys a put option with a strike price of ₹1,350, which will cost him ₹50 per share.

Now, if the price of the shares drops to ₹1,200, Rajesh can still sell his shares at ₹1,350, thanks to his put option. This way, he limits his loss to ₹50 per share (plus the cost of the put option) rather than losing ₹200 per share.

In summary, hedging allows Rajesh to manage his risk and safeguard his investments, much like how an insurance policy protects against unforeseen events.

Steps to Start Hedging with Options

Hedging with options can seem complex, but breaking it down into simple steps can make it easier to understand. Here’s a detailed guide for beginners:

1. Understand Your Risk

Before you start hedging, you need to understand the level of risk in your investment portfolio. Assess the stocks or assets you own and identify the potential risks. For example, if you own shares of a company and there are signs of a market downturn, you are exposed to the risk of your shares losing value.

2. Choose the Right Option

Options are contracts that give you the right, but not the obligation, to buy or sell an asset at a specific price. There are two main types of options:

(i). Call Option: Gives you the right to buy an asset at a specific price.

(ii). Put Option: Gives you the right to sell an asset at a specific price. 

3. Determine the Strike Price

The strike price is the price at which the option can be exercised. When choosing a strike price, consider the level of protection you need. Set the strike price accordingly if you want to limit your losses to a specific amount. For example, if you own shares priced at ₹1,400 each and want to limit your losses to ₹50 per share, choose a strike price around ₹1,350. 

4. Set the Expiry Date 

Options have an expiry date, which is the last date by which the option must be exercised. Select an expiry date based on how long you want to protect your investment. If you anticipate market volatility over the next three months, choose an option with an expiry date that covers this period.

5. Execute the Trade

Once you have decided on the option type, strike price, and expiry date, it’s time to execute the trade. You can buy the option through your brokerage account. Make sure to review the costs associated with the option, such as the premium (the price you pay for the option).

How Does Hedge Protect the Investors?

Hedging protects investors by mitigating potential losses. When you hedge with options, you essentially lock in a price for your asset. If the market moves against your position, the option gains value, compensating for the loss in the asset. This balanced approach helps maintain portfolio value and reduces volatility, providing peace of mind to investors.