How to Use Option Contracts to Hedge Your Investment Portfolio

Option contracts are a powerful tool used by several investors to manage risk and protect their portfolios from market volatility. By using intraday options trading strategy, you too can hedge against losses and allow your investments to safely ride the choppy waters of the stock market. Let’s find out more about this.

Understanding Option Contracts

An option contract gives you the opportunity to buy (call option) or sell (put option) the underlying asset (such as stocks or indices) at a predetermined price before a specific expiration date. 

But, you are not obligated to go through with the transaction if you do not find it profitable by the date of the contract’s expiration. The key types of option contracts are:

• Call Options: The right to buy the underlying asset at a fixed price (strike price) before the option’s expiration date.
• Put Options: The option to sell the base asset at a fixed price before the expiration date.

Why Hedge with Options?

Hedging with intraday options trading is a risk management strategy that helps reduce the downside risk in your portfolio while maintaining the potential for profit. 

It’s like taking out insurance on your investments. If the market turns against you, the losses from your core holdings can be offset by gains from your options contracts.

This approach allows you to:

• Limit potential losses without selling core holdings.
• Preserve upside potential while protecting against market downturns.
• Manage portfolio volatility, ensuring a smoother ride during turbulent times.

Strategies for Hedging with Option Contracts

• Protective Put: One of the most common hedging strategies is the protective put. This involves buying a put option for an asset you already own. A put option gives you the right to sell the asset at a specified price within a set time frame. This price is called ‘strike price’.
• Covered Call: It involves holding a stock for the long term while selling (writing) a call option on it. This strategy allows you to earn additional income (the premium from selling the option) but limits your upside if the stock price surges.
• Collar Strategy: The collar strategy is a combination of the protective put and the covered call. It involves owning a stock, buying a put option, and selling a call option. This strategy offers protection against downside risk while limiting the upside potential.

Factors to Consider When Hedging with Options

Here are some important factors that you should consider before using intraday option trading for hedging:

• Cost of Hedging: Buying options requires paying a premium, and the cost of hedging can reduce your profits. Be sure to balance the protection provided by the options with the overall cost of implementing the strategy.
• Time Decay: Options lose value over time, especially as they approach expiration. Be mindful of theta, or time decay, when planning your hedging strategy.
• Market Conditions: Not all market conditions are suitable for hedging with options. In a low-volatility market, for example, premiums might be too low to make selling options profitable.
• Strike Price Selection: Choose strike prices that align with your risk tolerance and expectations for the asset’s future movement.

Example Calculation of Hedging Using Protective Put

Let’s assume you own 100 shares of a stock currently priced at ₹ 1,000. You buy a protective put option with a strike price of ₹ 950 for a premium of ₹ 10 per share, totaling ₹ 1,000 for the option.

• If the stock price drops to ₹ 900, your shares would lose ₹ 10,000 in value (₹ 100 loss per share). However, the put option’s value will rise, compensating for the loss.
• You still keep any gains if the stock price rises, though you lose the ₹ 1,000 premium paid for the put.

Conclusion

Using option contracts to hedge your investment portfolio can be an effective way to mitigate risks and protect your investments from market volatility. 

Whether you’re using protective puts, covered calls, or more advanced strategies like the collar or straddle, understanding the nuances of these tactics can help you manage risk while still capturing potential gains. Proper risk management through options can lead to more consistent returns, even in uncertain markets.

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Frequently Asked Questions

1. What are option contracts?

Answer: Option contracts are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time frame. They are typically used for hedging or speculating on price movements.

2. How can option contracts be used to hedge an investment portfolio?

Answer: Option contracts can be used to hedge against potential losses in an investment portfolio by purchasing put options, which give the holder the right to sell the underlying asset at a set price. This can protect against declines in the value of the underlying securities.

3. What is a put option, and how does it work?

Answer: A put option is a type of option contract that grants the holder the right to sell a specified amount of an underlying asset at a predetermined price (the strike price) before or at the expiration date. If the market price of the asset drops below the strike price, the holder can sell at the higher strike price, mitigating losses.

4. What is a call option, and how can it be used in hedging?

Answer: A call option is an option contract that gives the holder the right to buy an underlying asset at a specified price within a certain timeframe. In hedging, investors might use call options to protect against potential increases in the price of an asset they plan to buy in the future.

5. What are the risks associated with using options for hedging?

Answer: The primary risks include the potential for losing the premium paid for the option if the market does not move as anticipated. Additionally, options have expiration dates, which can limit their effectiveness if market conditions change unexpectedly.