Options Hedging Explained- How to hedge your equity positions with Options?

Published on Friday, October 5, 2018 by Chittorgarh.com Team | Modified on Monday, March 11, 2024

Options are complex instruments compared to shares. But they offer numerous advantages. One of the main advantages is the use of options as a hedging instrument. You can use call or put options to hedge your equity positions. Many fund managers and experienced traders trade options in particular to hedge their equity portfolios. As a retail investor, you can do this too. You just need to understand how options work and how you can use them to protect your stock portfolio from losses.

What are Options?

Options are one form of derivative. The other form is futures. Simply put, options are financial instruments that derive their value from an underlying asset. Depending on the asset from which they are derived, there are stock options, index options, currency options, and commodity options. For example, stock options refer to the shares of a particular company, and index options refer to indices such as the Nifty 50, Bank Nifty, etc.

Options are contracts between a buyer and a seller. They give you the right to exercise the contract, but not the obligation. A simple example would be that you want to buy a house. You liked a particular house. You have paid a small portion of the cost of the house to the owner, with the agreement that you will pay the rest of the amount in the next 30 days. Now you have the right to buy the house or not. The most you will lose is the money for the down payment. The owner can also sell the house later or refuse to sell it. Options work similarly, with the difference that the seller is obliged to fulfill the contract. So with options, the buyer has the choice to fulfill the contract, not the seller.

There are two types of options: call options and put options. Call options are used when the price of a stock is expected to rise, while put options are used when the price is expected to fall.

There are some important differences between options and shares:

1. Options have a predetermined expiration date. It can be 1 month, 2 months, 3 months, or weekly.
2. Options are traded in lots, i.e. a group of shares determined by the exchange.
3. You do not pay the full value of the shares, but a premium. Suppose an option has a lot size of 100 shares and the price of each share is 40 rupees. Instead of paying 4000 rupees, you would pay a premium that is far less than the value of the share.

Option Hedging Meaning

Option hedging is a technique used by traders to hedge their investments in the respective underlying assets. Hedging strategies reduce uncertainty and limit losses without significantly reducing the potential return.

Options and Hedging - How to use options as a hedge?

They work on the premise that a loss in one segment is offset or minimized by a gain in another. Stock options are derived from the stocks of the companies. Large companies like Reliance, SBI, TCS, etc. have their Options traded on the stock exchanges. The performance of these Options is linked to the performance of the company's shares. If the share price increases, the value of the option also increases and vice versa. There is also a difference in the cost of buying shares and options. When buying shares you pay the actual value, when buying options you pay a premium. In addition, with Options you can not only make profits when the market rises, but also when the market falls.

Let us assume you hold 1000 shares in a company. You think it is a good share and want to hold it long-term. However, you fear that the company's results will fall short of expectations next month and that the share price will fall in the short term. You would like to protect your position against this downturn. You enter into a position on the options market on the assumption that the share price will fall. If the price now falls, you earn money with the Options, but notionally lose the value of your holdings. Depending on the actual trade, you will therefore either cover or minimize your loss in your holdings. If the stock price rises contrary to your assessment, your holdings gain in value and you lose the premium paid for the Options. In this way, you hedge or insure your stock positions with Options.

How do options hedge risk?

Options hedging can help a trader protect their investments in the following ways:

• Limit losses: Hedging helps traders limit their losses if the price of the underlying asset moves in a different direction. If the price moves against the investor, he can sell shares, and the option to limit the loss.
• Price clarity: Individual investors and companies use derivatives to remove uncertainty about the future prices of commodities or assets. By using options hedging strategies, investors can lock in the prices of key/primary commodities long before the delivery date.

Option Hedging Techniques

• Short hedge: A short hedge is when a short position is entered into to hedge shares, futures or commodities. A short hedge is entered into when an investor assumes that the price of the future will fall.
• Long hedges: With a long hedge, a long position is taken to hedge shares, futures or commodities. A long hedge is entered into when an investor assumes that the price of the future will rise.
• Static hedge: A static hedge is when the number of positions is not increased or decreased, i.e. bought or sold, and remains constant regardless of the price development of the hedging instrument.
• Dynamic hedge: A dynamic hedge is when an increasing number of hedging contracts are bought and/or sold during the term of the hedge in order to influence the hedging ratio and move it in the direction of the desired hedging ratio.

Options Hedging Strategies

Various strategies can be used to hedge a stock position. Some of them are listed below.

Using Put Options to Hedge Stock Positions

Example:

• Covered put: This strategy involves taking a short position in the stock and selling a put option. The shorted put is usually an OTM put option. In this strategy, when you sell shares (or futures), you also sell a put option (ATM or slightly OTM) to cover an unexpected rise in the share price. The covered put is a neutral to bearish view of the market and assumes that the price of the underlying will stay within a certain range or fall. Read more.
• Synthetic call: In this strategy, the share is traded and a put option is bought. A synthetic call strategy is used by traders who currently hold the underlying asset and are bullish on the long term. However, he is also concerned about the downside risks in the near future. This strategy offers unlimited return potential with limited risk.

If the price of the underlying rises, you make a profit on your holdings. If it falls, your loss is limited to the premium paid for the PUT OPTION. Read more.

Using Call Options to Hedge Stock Positions

Example:

• Protective call: This strategy involves taking a short position in the stock and buying a call option. In this strategy, a trader takes a short position in the underlying asset (sell shares or futures) and buys an ATM call option to hedge against the rise in the price of the underlying asset.

This strategy is the opposite of the synthetic call strategy. It is used when the trader takes a bearish position in the underlying asset and wants to hedge against an increase in the price of the underlying asset. Read more. 

• Covered call: In this strategy, the stock is held and the call option is sold. A covered call option is a basic options trading strategy often used by traders to protect their large shareholdings. In this strategy, you own shares in a company and sell an OTM call option on the company at a similar ratio. The call option is only exercised if the stock price rises. Until then, you earn the premium. Read more.

Example- Hedging equity with Put Options

Suppose you are holding 1,000 shares of an ABC company at Rs 1,000 per share. After 2 months, the stock price moves up to Rs 1,200.

Your initial investment= 1000 X 1000= Rs 10,00,000

Your current holding value= 1000 X 1200= Rs 12,00,000

Your notional profit= Rs 2,00,000

You fear the price will go down to around Rs 1100 next month but don't want to sell your holdings as you're expecting big profits in long term. You can hedge your current equity holdings by buying 5 Put Options with lot sizes of 200 shares each. You pay a premium of Rs 5 per share.

You buy 5 Put Options with a lot size of 200 shares i.e. total 1000 shares.

You pay a premium of Rs 5 per share i.e. Rs 5000.

Now, if the price moves down, the value of your Option will increase and vice versa.

As per your expectation, the price of the stock dipped to Rs 1150 next month. The premium price went up to Rs 15.

Current value of your equity holdings= 1000 X Rs 1100= Rs 11,50,000.

Past value of your equity holdings= 1000 X Rs 1200= Rs 12,00,000.

Your notional loss on holdings= Rs 12,00,000- Rs 11,50,000= Rs 50,000.

The value of your Options= 1000 X Rs 15= Rs 15,000

Profit from Options= Rs 15,000- Rs 5000 (premium paid)= Rs 10,000

So your net notional loss = Rs 50,000- (Rs 15,000- Rs 5,000)= Rs 40,000.

This is only a notional loss as you are not selling your equity holdings. So whenever the stock price moves back to Rs 1200. You will actually make a net gain of Rs 10,000.

Example- Hedging equity with Call Options

Experienced traders do not just take a single position in options. They take several options to reduce the cost of hedging. Your previous trade is: You hold 1000 shares of the company worth Rs. 12,00,000.

You buy a put option worth 1000 shares and pay a premium of Rs. 5000 for it.

Suppose you also sell a 5 Call Option of the company. For selling options, you will earn a premium. Suppose the premium per share is Rs 3. The total premium earned by you is Rs 3,000.

Now your trade is-

Holding of 1000 shares of the company worth Rs 12,00,000.

Buying Put Options worth 1000 shares by paying a premium of Rs 5000.

Selling Call Options worth 1000 shares and earn a premium of Rs 3000.

Your net premium outgo in Options = Rs 2000.

Continuing the above example,

The value of your Options= 1000 X Rs 15= Rs 15,000

Profit from Options= Rs 15,000- Rs 2000 (net premium outgo)= Rs 13,000

So your net notional loss = Rs 50,000- Rs 13,000= Rs 37,000.

Hedging with Options is risky. And traders must assess the risks involved before taking the positions. But if done right, it can give you good returns and help you hedge your equity positions.

Delta Hedging

Delta hedging is an options hedging strategy used to reduce the impact of price fluctuations on a portfolio. 

Delta Hedging Meaning

Delta hedging limits the directional risk associated with the price movements of the underlying asset. The ultimate goal is to achieve a delta-neutral state. It involves the purchase or sale of options and the simultaneous purchase or sale of a corresponding number of shares.

Options Hedge Ratio

The options hedge ratio is the ratio or comparative value of the hedge of an open position to the total position. It is used to measure the extent of the potential risk that can be caused by a movement in the hedging instrument. 

Hedge Ratio Options Formula

A hedge ratio of 1, i.e. 100%, means that the open position is fully hedged. A hedge ratio of 0 or 0%, on the other hand, means that the open position is not hedged.