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

Published on Friday, October 5, 2018 by Chittorgarh.com Team | Modified on Thursday, June 6, 2019

Options are complex instruments when compared with stocks. But it provides multiple benefits. One of the major benefits of Options is hedging. You can use Options, Call or Put, to hedge your equity positions. Many fund managers and experienced traders chiefly trade in Options to hedge against their equity portfolio. You, as a retail investor, too can do it. All it takes is some understanding how Options work and how to leverage it to protect any downside to your equity portfolio.

What are Options?

Options are a form of derivatives. The other form is Futures. In simple words, Options are financial instruments that are derived from an underlying asset. There are stock options, index options, currency options and commodity options based on the asset these are derived from. So stock options is derived from stocks of a particular company, index options are derived from indices like Nifty 50, Bank Nifty etc.

Options are contracts between a buyer and a seller. It gives you right to exercise the contract but not the obligation. A simple example would be, say you want to buy a house. You liked a particular apartment. You paid a small part 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 or not to buy the house. At max, you will lose the deposit money. The owner may also sell or decline to sell the house later. Options work similar to it except for the fact that the seller is obligated to honor the contract. So, in Options, a buyer has a choice to honor the contract or not but not the seller.

Options are of two types: Call and Put Options. Call options are used when the price of a stock is expected to move up while Put options are used when the prices are expected to come down.

There are some crucial differences between Options and stocks?

1. Options have a predetermined expiry date. It can be 1 month, 2 months or 3 months.
2. Options are traded in lot sizes which is a group of stocks determined by the exchange.
3. You don't pay the full value of stocks but a premium. Say an Option has 100 shares as a lot size and each share price is Rs 40. But, instead of paying Rs 4000, you would be paying a premium amount which is much smaller than the share value.

How to use Options as a hedge?

It works in the premise that loss in one segment is negated or minimized by profit in other.

Stock options are derived from stocks of the companies. Major companies like Reliance, SBI, TCS etc., have their Options traded in the exchanges. The price movement of these Options is linked to the price movements of the stocks of the company. If the price of the stock moves up the value of the Option moves up and vice versa. There is also a difference in the cost of buying stocks and options. You pay actual value to buy stocks but pay a premium to buy Options. Also, Options allow you to make a profit not only when the market is up but also when markets are down.

Let's say you are holding 1000 shares of a company. You believe it is a good stock and wants to keep it for a long term. But, you fear the company results in coming next month may not be as per expectations and the price of the stock will go down in short term. You want to protect your holdings against this downturn. You take a position in the Options market as per your view that the price will go down. Now when the price goes down, you make money in Options but notionally lose value in your holdings. So depending on the actual trade, either you will cover or minimize your loss in the holdings. If the stock moves up, contrary to your view, your holdings gain value and you lose the premium paid on Options. This how you hedge or insure your equity positions with Options.

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 don't just take a single position in Options. They take multiple options to bring down the cost of hedging. Your trade so far is-

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

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

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.