Hedging with Options – Trading in turbulent markets

Hedging with Options – Trading in turbulent markets

You might be a new entrant in the world of Trading or a regular investor in Equity. Either way, trading in turbulent markets requires you as an investor to have a good understanding of how to make profits while reducing risks to a minimum. The regular strategy of identifying one or two good stocks or buying a call on it will only work for a while. In the longer run, you’ll need to know how to take advantage of the movement. An unhedged portfolio can lead capital erosion and while this is a universal truth, it is especially pertinent during high market volatility. Hence – Hedging! This basically means avoiding losses on one investment by investing in another to specifically protect the earlier investments made. There are many different ways of Hedging, one of which is Options Hedging where you minimize losses on investments made in the Cash markets by taking a corrective position in the Derivatives market. If you do not wisely use Hedging as a tool to safeguard your investments, you could end up making big losses. Many a times, especially when the markets are highly volatile, one can hear investors say that they have suffered losses and do not intend to reenter markets. If you are smart, you can use small tools to ensure that you are not caught in such a situation. This blog briefly touches on how to use Options to minimize losses suffered in Cash market investments. But before getting into Hedging with Options, you need to understand Options Pricing and Implied Volatility.

Option Pricing is simply the amount per share at which the Options is traded. Trading in Options makes you eligible to buy or sell a stock at an agreed price up to a certain decided date. Apart from the underlying priced of the stock, the price of an option is also determined by its intrinsic value – the amount the strike price of an option is in the money, its time value – the time an option has until the contract expires and the volatility in the underlying security of an option. The ever-changing market and its uncertainty defined as volatility which can be used to an advantage if the right move is made at the right time. For that, you can choose to fall back on historical volatility or decipher the future of the market with Implied Volatility. A metric used to calculate the probability and volatility of the market in the future. Implied Volatility helps show the market’s opinion of the stock’s potential movement. It helps you gauge the impact on your underlying stock. You can measure your trade’s risk and identify a potential risk-reward coming your way. 

Although the above might seem overwhelming at first, let us break it down with the help of a simple example to better understand how Options can be used as a protective tool against market volatility. Say that you have purchased 1 share of ABC Ltd @ INR 566. Prior to investing you had done your due diligence and found the fundamentals of ABC Ltd to be strong and hence are assured of long term returns. However, as soon as you purchased the share, the price of ABC Ltd dips from INR 566 to INR 500. This was largely due to the overall negative sentiment in the market and may not have much to do with the company. However, you are now having a notional loss of INR 66. Further let us assume that the turmoil in the markets continued and the price of ABC Ltd fell to INR 450. In this case, you have made an overall loss of INR 116 to your initial investment which in percentage terms means that your asset has eroded over 20%. However, if you have invested smartly, you can minimize the overall effect of the market’s negative sentiments. While purchasing ABC Ltd @ INR 566, you could have bought a Put Option for e.g. ABC Oct PE at INR 560 strike for a premium of INR 18. It means that by paying a premium of INR 18 i.e. approximately 3% (cost of the Hedge) you are now effectively cushioning the losses in the Cash market. When the share price goes to INR 500, while in the Cash market, you have lost INR 66, in the Options market; you have made INR ~ 60 on your Hedge. Effectively, you Net Losses are reduced from INR 66 to INR 24 (INR 18 which is the cost of the Hedge + INR 6 which is the difference between the loss in the Cash market and the profit made on the Hedge). Similarly, when the market price of ABC Ltd corrects to INR 450, while you stand to lose INR 116 in the Cash market, you make INR ~ 110 on the Hedge which means that effectively, once again, your losses stand at INR 24 (INR 18 which is the cost of the Hedge + INR 6 which is the difference between the loss in the Cash market and the profit made on the Hedge). One can ask, what happens, if the market price of ABC Ltd shoots up to INR 666? Well, in the case, you do not exercise your option and hence only loose the premium amount i.e. the cost of the Hedge INR 18. This effectively means that by putting 3% of the value of the share, you have safeguarded yourself against choppy markets.

Such strategies ensure that capital erosion is cut to a minimum while taking into account market volatility.  We hope that the above article has been helpful in understanding about Hedging with Options.