Options were introduced with the explicit purpose of being used for hedging. Hedging is an excellent tool to limit your risk by taking an offsetting position to the trade taken. In simpler terms, it involves taking a contra position along with the intended trade. Markets are unpredictable, and many times the trend may not follow the view of the trader. Herein hedging comes in handy to limit one’s risk.
But what does option hedging mean anyway?
An options contract is a financial derivative instrument that derives its value from an underlying asset. The most common underlying asset is stocks; however, the benchmarked asset could also be a debt instrument or a commodity. An options contract offers the trader the option but does not impose the obligation to buy/sell the underlying asset at a specified price. Trading in Options remain valid for a predetermined period only.
Hedging is an investment strategy. To ‘hedge’ means to reduce an investor’s risk, and options and other derivative instruments are tools for achieving hedging goals.
Is option hedging a good trading strategy?
In principle, option hedging is an excellent tool if used correctly. Hedging caps the profit for you, but at the same time, limits the risk as well. The best part about option hedging strategies in India is that there is no need for a stop loss while taking up a trade. This elimination is a significant advantage in markets where there are no stop loss facilities for overnight positions. The maximum profit and maximum loss are already pre-defined in the strategy, allowing you to sleep peacefully even with overnight positions.
Let’s have a look at some crowd favourite hedging strategies
Option hedging strategies in India are such that traders can use them in various market scenarios. Types of hedge strategies range from simple and widely used ones like Strangles and Straddle to more complex ones like Call/Put Ladders, Ratio Spreads, Butterfly, and Iron Condor. Some other strategies that are popular with investors include Covered Call and Secured Put.
What is call option hedging?
A call option hedge example would be taking a contradictory position in the underlying asset or another derivative. If an investor has purchased a stock that is currently stagnant or is going down, they can sell a call option to hedge the overall portfolio. Hedging to buy an option is also becoming popular. If you decide to buy a call option, you can simultaneously buy a put option or sell another call option to mitigate risk. Buying an option is simple; you can execute the trade yourself or ask your broker to do it for you. To hedge your exposure, plan your trades and take positions accordingly.
Final takeaway
Some strategies offer a risk-reward ratio of 1:2 or even better. All-in-all, hedging is a tool that allows you to trade without fretting. As the risk is limited and pre-defined, it allows you to hold positions longer and take an exit at an appropriate time. If you devise the strategy appropriately, then you will land in the green more often than not. If options hedging seems overwhelming, you can consult a financial expert for guidance to trade in future & options.
