Hedging with Options

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Oct 8, 2021
Behailu Tekletsadik
I’m not good with puns

What comes to your mind when you hear the term “hedging your bets”? It might conjure up sports imagery or a scene from Wolf of Wall Street.

In both scenarios, the goal is to mitigate risk and protect the initial investment.

Hedge funds get their name from the practice of investing in one security, hoping for a substantial return, as well as investing in a different security that will pay off if their initial investment goes against them.

At its core, all investment hedging works like that, so how does it apply to options?

Today we are going to discuss hedging and how to implement risk management strategies in your options trades.

Our goal is to provide retail investors like you with the tools and information to set you up for success over your trading career here at Lantern.

How hedging works

Before we discuss how to build an options hedging strategy, we need to make sure that we understand the concept of hedging.

Many investors compare a hedge to an insurance policy on an investment.

Although insurance policies are much more exact than any hedging strategy could be, the analogy serves a practical purpose because it conveys the concept of risk mitigation.

Risk is an essential component of investing, but it is also the most dangerous if left unchecked.

Investors with significant long-term positions may want to reduce their exposure in the short-term.

The most efficient way to reduce your position’s exposure to market volatility is to head your investment with a security that is inversely correlated.

Inversely correlated securities should move in the opposite direction that your portfolio is moving. For example, if you have a long Equity position in XYZ Corporation, but you are worried about negative earnings next quarter, you can open a simultaneous short position by buying a put option, selling a call option, or short selling a stock.

We will discuss these strategies in more detail. Still, all three of these strategies’ overarching goal is to reduce short-term losses in your equity position if the stock price goes down.

Instead of profiting from your short position, the appreciation from the share price going down will offset the losses of your long position in XYZ.

Hedging Strategies

First, we’re going to look at simple Hedges to reinforce the concept of hedging your investments with options.

Holding Underlying

If we look back to our previous example with XYZ company, and you still are long 1000 shares, you can enter into a short position at the same time by Short Selling shares.

Although this is not the most efficient way to hedge a long stock position, it’s still worth mentioning because it is a prevalent hedge fund strategy.

When one short sells shares in a company, they essentially borrow these shares from their brokerage. If the price goes down, they will repurchase them at the lower price, and the difference between the short sell price any price that they repurchased their shares will be their profit.

You can probably guess that if you are wrong about the trade direction, you will be on the hook for the opposite scenario in which the shares go up. You need to cover for your loss, which will be the difference between what you shorted the stock and what its higher price is now.

Buying and Selling Options

Options make it much simpler to hedge positions either against other options trades or against Equity positions.

Calls

Calls are typically viewed as bullish securities because their value is directly correlated to the underlying security price if you buy them.

Since calls give you the right to buy a particular stock at a specified strike price, you may be wondering how you would hedge a long position with a long instrument.

In this case, you would sell call contracts against the underlying security. This would result in you taking a premium payment to your account, which would generate income as long as the share price fell as you anticipated.

The risk to selling calls against your portfolio is the potential for the share price to go up, in which case you could be assigned.

When you are assigned, the contract and stipulations of the option are being called by the contract buyer. This means that you would need to deliver on what the terms of that specific options contract dictate.

Fortunately, if you own the underlying shares, you would be able to exchange those with the option buyer which would cover your position.

If you did not own any underlying shares and wrote a naked call where the shares spiked, it would be similar to being short squeeze and paying the difference between the strike price and share price.

Puts

When it comes to hedging long Equity positions, puts the preferred security to do this with Because long puts are inversely correlated with the underlying share price.

For example, with XYZ company, you would buy an out-of-the-money put, which would only become in the money if your XYZ shares lost a lot of value in a short amount of time.

Utilizing Puts is a great way to hedge a long position for two reasons:

  1. Your maximum loss on the trade is the premium you paid for the contracts. This means that if your long position continues to appreciate, your hedge will not incur further losses.
  2. Suppose your Equity position nosedives, and you lose a lot of capital gains. In that case, the put option will appreciate, which can help you either net to zero on the position or potentially profit from your short hedge.

When you buy a put to hedge against a long Equity position, you have the added benefit of structuring your trade so that the put expires worthless on a date you specify without worrying about any further losses.

Spreads

Finally, experienced option Traders utilize spreads for advanced edging techniques such as calendar Spreads where you would buy a long-term put option and sell short-term options against it to generate income and reduce your total cost.

Developing a Plan

Hopefully, now you can see that hedging is not some esoteric investment term; instead, it is the practice of protecting your positions against short and medium-term risk.

Although it’s impossible to eliminate portfolio risk, effective hedging strategies can help you or returns stay consistent. They will teach you valuable risk management strategies.

By utilizing Lantern’s database and platform, you can perform an immense amount of research on companies to invest in and analyze the options available to create hedging strategies.

Not only does Lantern allow you to performed research on your own, but we also connect you with some of the most potent strategies hedge funds and other institutional investors use in their trades.

Check out our API here or download our app here.


Hedging with Options was originally published in Lantern on Medium, where people are continuing the conversation by highlighting and responding to this story.