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Hedging strategies using

options

Meaning of hedging

Hedging is the process of reducing the risk of


unfavorable price movements in an asset.

Investors use this strategies when they are


not sure what the market will do.

Example : if an investor owns a stock of reliance power


and decides to sell it on a futures contract at the stated
price on a future date irrespective of what the market
price is on that date , therefore avoiding market
fluctuations.

options
options

Put options

Call options

Meaning of options

Options
it gives the buyer the right but it is not an obligation to
buy or sell stock / currency /camodity of the specified
amount at a specified period of time.

The seller has no right but has an obligation to buy or sell


an asset if the buyer exercises his right.

The buyer of an option pays a premium to the seller for


ganing the right to buy or sell.

Types of options
Option
types

Buyer of
option

Call option

Right to buy
asset

Writer of
option
(seller of
option)
Obligation to
sell asset

Put option

Right to sell
asset

Obligation to
buy asset

Hedging a short position in stock

When an investors holds a stock for a long period of


time and if he feels the price is gong to decline of the
stock he will decide to shot sell that stock with an
intention to buy it at a lower price in future.

The investor dose this with an intension of making


profit.

But if the stock rises the investor has to face looses


because h has an obligation to purchase at a future
date.

Hedging a short position in stock

Now in order to menimise the risk involved the


investor can buy a call option.

With a strike price that is equal or close to the


selling price.

Example: an investor shorts a share at Rs100 and


buys a call option for Rs 4 and if the strike price is
Rs 105.

Hedging with write call and put option

If an stock is not expected to experience


significant price difference in the short run then
the strategy of writing call (sell calls) and put may
be useful for this purpose.

Example: if an investor expects small change in


prices in the stock that they hold in an short term
and then write a call on these stock. This is
known as a covered call.

By selling a covered call option you tend to raise


short term returns.

Hedging with write call and put option

However there will be no benefit if


the large price changes occur
because the option will exercised or
the investor has to reverse the
transaction.

Hedging a short position in stock

Now in order to menimise the risk involved the


investor can buy a call option.

With a strike price that is equal or close to the


selling price.

Example: an investor shorts a share at Rs100 and


buys a call option for Rs 4 and if the strike price is
Rs 105.

Bull call spread

Under this strategy investor at once will purchase


a call option at a definite strike price and sell the
same number of calls at a higher strike price.

Both call options are for the same underlying


asset and have the same expiry month.

This strategy is used by investors who are bullish


who are willing to take the risk and expects the
sock prices to move up

Bull call spread

Under this strategy investor at once will purchase


a call option at a definite strike price and sell the
same number of calls at a higher strike price.

Both call options are for the same underlying


asset and have the same expiry month.

This strategy is used by investors who are bullish


who are willing to take the risk and expects the
sock prices to move up

Hedging using Options strategies

Covered call

Married put

Protective put

Collar

Long straddle

Long call

Put bear spread

Call bull spread

Delta neutral hedging

This is one of the complicated


techniques using options.
Delta neutral means a portfolio that
has an overall delta value of zero or
close to zero
This means that the portfolio does
not react to any small change in the
price of underlying asset.

Delta neutral hedging

It is an options technique used to


protect from short term price
movement.
Advantage: it dos not only help the
investor position from small price
changes but also helps the investor
to earn profit from that point were
the stock rises or falls strongly.

Example:

Covered call

Investor holds a long position in the asset.

The seller sells the call options on the same asset


with an intention to increase income from the
asset.

It is also used by large funds in order to generate


consistent income from sold options.

Covered call

It is called as a buy write strategy.

Example: if you own a stock at Rs 10 and thinnk


that the price will not increase soon but will
increase later then you can sell at call Rs 12. this
gives rise to 2 cases

Case 1:if the stock does not rise by Rs 12 by the


expiry of the option date you earn the contract
price and loose nothing.

Covered call

Case 2: 1:if the stock rises by Rs 12


or more the option probably would
have expired but you will have
collected the premium and sold your
stock there by making a profit of Rs
2.

Married put

Investor buys shares in a company and at


the same time buys a put option.

The strike price of which is lower then the


current market price.

The investor purchases a put option in


order to protect against fall in stock prices

Married put

Case 1: if the price goes up or in


other words rises the put option is
of no value and it expires.

Case 2:if the price rises the put


option is exercised and the investor
will recover some of his looses.

Bear put spread

Under this strategy investor at once will purchase a put


option at a definite strike price and sell the same
number of puts at a lower strike price .

Both options are for the same underlying asset and


have the same expiry date.

This method is used when the seller expects the price


of underlying asset to decline.

This strategy offers both limited gain and limited


losses.

Bear put spread

The maximum profit that can be


earned through this method is equal
to the difference between 2 strike
prices minus the net cost of options.

Example:

Bull call spread

Under this strategy investor at once will purchase


a call option at a definite strike price and sell the
same number of calls at a higher strike price.

Both call options are for the same underlying


asset and have the same expiry month.

This strategy is used by investors who are bullish


who are willing to take the risk and expects the
sock prices to move up

Protective put

It is a hedging stretegy.

A holder buys a put option on the underlying assets


that he already owns.

This put option is bought in order to protect from fall in


the price of the stock of the security he owns.

This strategy is mostly in use when the options trader


is bullish on a stock he already owns but is subspecies
of uncertainties in the coming period.

Protective put

The protective put is also known as synthetic long


call as the risk or reward profile is same as that of
long call.

Example: The price of share of bajaj is Rs215. a


guaranty against the price fall below Rs210 before
expiry may be achieved by purchasing a put
option with a strike price of 210

The premium for the put option will be 10 per


share

Protective put

Case 1 :The option will pay off any loss


resulting from a fall in price below Rs210.

Case 2:if the expiry price on the share is


above Rs210 then there is no payment on
the guaranty given and the investors loss
will be equal to the premium paid .

Collar

Collar is an option strategy that is


constructed by holding shares of the
underlying stock.

And at the same time buying a


protective put option and a selling
call option against the stock.

Collar

Long call

Under this strategy the option trader buys call


options with a hope that the price of the
underlying securities will rise beyond the strike
price before the option expires.

This is an simple way to benefit if you fell the


market prices will go up.

This strategy is mostly used by first time


investors.

Long call

If the stock prices do no go up above the strike


price before the option expires the option is
useless.

There is no limit on the maximum profit when the


long call option is implemented.

The risk in long call option is limited up to the


price paid for the call option no mater how low
the stock price are traded on the expiration date.

Long straddle

Investor purchases both put and a call option with


the same strike price, underlying asset and same
expiration date.

This strategy is used by the investor when he feel


that the price of the underlying asset will move
considerably.

But is not sure in what direction it will move


whether it will rise or fall.

Long straddle

In this strategy the investor has an


unlimited gain.

Loss is limited only up to the


premium paid in establishing the
position.

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