Hedging is a strategy used by investors to reduce or eliminate the risk of holding one investment position by taking another investment position.
Option contracts are a great tool to use to hedge against risks in underlying stocks. From this article, investors will gain the necessary knowledge to start using options as a hedging technique in their own investing portfolio.
Hedging protects an investor’s portfolio from loss. However, hedging results in lower returns for investors. Therefore, hedging is not a strategy that should be used to make money but a strategy that should be used to protect against losing money.
In order for hedging to work, the two investments must have a negative correlation. Thus, when one investment falls in value, the other investment must rise in value. This is where options come in.
For example, assume an investor buys 100 shares of XYZ stock at $100. The investor is bullish on the stock but is also nervous that the stock may drop in the near future. To hedge against a potential fall in the stock, the investor buys a put option for $1 per share. The put option expires in three months and has a strike price of $90. This option gives the investor the right to sell the XYZ shares at $90 any time in the next three months.
Assume that in three months, XYZ is trading at $110. The investor will not exercise his put option. He will gain $10 from the increase in stock price from $100 to $110. However, he loses the premium of $1 per share that he paid for the put option. Therefore, his total gain will be $9 per share.
Alternatively, assume that XYZ is trading at $50 in three months. If that happens, the investor would exercise his put option and be able to sell XYZ shares at $90 rather than $50. By doing this, he loses $11 per share rather than $51 per share. The put option saves the investor from a substantial loss.
For another example, let’s look at a call option being used to hedge. Assume an investor is short selling 100 shares of XYZ that is currently trading at $100. An investor expects the stock’s price to decrease but he wants to protect against a possible increase in the near future. To hedge against a possible increase in price, the investor buys a call option for $2 per share. The call option expires in a month and has a strike price of $98. This option gives the investor the right to buy the XYZ shares at $98 any time in the next month.
Assume that in a month, XYZ is trading at $90. The investor will not exercise his call option. He will gain $10 from the short selling the stock from $100 to $90. However, he loses the premium of $2 per share that he paid for the call option. Therefore, his total gain will be $8 per share.
Alternatively, assume that XYZ is trading at $120 in a month. If that happens, the investor would exercise his call option. From the short position, the investor will lose $20 per share as the stock increases from $100 to $120. But by exercising the call option, the investor will buy XYZ at $98 then be able to sell XYZ at the market price of $120. From the call option, the investor makes $22 per share. However, do not forget about the premium that was paid for the call option which cost $2 per share. Therefore, the investor breaks even by hedging (22 – 20 – 2 = 0).
After looking at these two examples, investors should realize how valuable hedging can be in their own investing portfolio. Put options and call options are both great tools to help limit or eliminate loss when an investor is uncertain about the future movement of a stock’s price.