It is so simple to hedge with options; here is how

Stock Market | Published on 24th May 2018 | 162 [Sassy_Social_Share]

If you thought trading in options little bit like rocket science, then you are not exactly to be blamed. That is what futures & options are made out to be in the markets. They are presented as some exotic product that is abstruse and hard to comprehend. For a moment let us forget about speculating and trading using options. OK, let us also forget about futures for now. Is it possible to understand options in very simple and elementary terms? The answer is an emphatic “Yes”. Let us look at how options can be used for hedging your risk and how it actually works. But before that, here are 3 very important points about options you need to grasp before we go ahead

3 points to grasp about options to begin with…

  • An option is a right to buy or sell an asset at a fixed price and for a fixed expiry (maturity). A right to buy is known as a call option while the right to sell is a put option.
  • The buyer of the option (call or put) has to pay a premium for getting this right without obligation. This price of the (right without obligation) is called the option premium or option price. That is what you get to see on your trading terminal.
  • Option prices have two components viz. intrinsic value and time value. While intrinsic value is the difference between market price and strike price, time value is the value you assign to the option based on time to expiry. This time value slowly moves towards zero as expiry nears.

Case 1: Hedging with options when you have purchased shares

Let us assume that you had purchased 1500 shares of Tata Motors at Rs.380. However, the stock subsequently corrected to Rs.320 resulting in a notional loss of Rs.90,000/-. Since you are a long term investor you do not believe in stop losses but is there a better way you could have protected yourself. The answer is in using put options to hedge your risk. The word “Hedge” here means “to protect your risk”. Let us consider an illustration…

Bought 1500 shares of Tata Motors at Rs.380 & one 370 Put Option @ Rs.4

Market Price Scenarios

Profit/loss on stock

Profit / loss on option

Total Profit / Loss

Rs.300

-80

+66

-14

Rs.310

-70

+56

-14

Rs.320

-60

+46

-14

Rs.330

-50

+36

-14

Rs.340

-40

+26

-14

Rs.350

-30

+16

-14

Rs.360

-20

+6

-14

Rs.370

-10

-4

-14

Rs.380

00

-4

-4

Rs.390

+10

-4

+6

Rs.400

+20

-4

+16

Rs.410

+30

-4

+26

Rs.420

+40

-4

+36

 

Understanding how the hedge actually protects the investor

As can be seen from the above illustration, on the downside the maximum loss is limited to Rs.(-14) while the upside profits are unlimited. That is because the maximum loss on the option is limited to Rs.4 which is the premium that you have paid on the option. That is your maximum loss on the option, irrespective of how high the stock goes. On the upside, once your option premium cost of Rs.4 is covered; your net profits start at that point. But what about the downside risk?

Remember, a put option is a right to sell. When you buy the Tata Motors 370 put, you are actually buying a right to sell (without obligation) Tata Motors at Rs.370. So, you have a loss of Rs.10 on the transaction (380-370), which is the difference between the price at which you bought the stock and the price at which you bought the put option. To that you add Rs.4 which you paid as option premium as that is your sunk cost. That gives you a total loss of Rs.(-14), which is the maximum loss you will incur, even if the stock price of Tata Motors goes down all the way to Rs.100.

But what should you do once the option expires? If the price movement is against you then you can just close out the stock and the option and book a maximum loss of Rs.(-14). Alternatively, you can book profits on the put option once the stock price reaches close to the support. If you don’t want to do either of these things, then you can just keep buying a new option every month and that will entail you a cost of around 1% per month.

Can I still hedge using options if I am short on Futures?

That answer is, “Yes you can”. Since traders are not permitted to short sell in the cash market for more than a day; one way is to sell futures. Suppose you sell Reliance Industries futures at Rs.980. You will make a profit if the price goes down. But what if the price goes up? You can hedge your short futures by buying a call option. Assume that you buy an Rs.990 Call option on RIL at Rs.10; then what is the protection that you get?

Short Futures

Amount

Call Option

Amount

Futures of RIL sold at

Rs.980

If price of RIL goes to

Rs.1050

If price goes up to

Rs.1,050

Profit on Call Option

Rs.60

Loss on short futures

Rs.70

Option Premium Paid

Rs.10

Hedge by buying

990 Call @ Rs.10

Net Profit on Call

Rs.50

Max Loss on position = Rs.(-20)

Max Profit – Unlimited on the downside

That is how options can be used to hedge (protect) your risk in a very simple way! You surely now agree that there is not much of rocket science to hedging with options!