Options Hedging Strategy

Options hedging helps you reduce the downside risk of an investment by taking another position that may benefit when the original investment loses value.

• A protective put can limit losses when the price of an asset falls.
• A covered call can generate premium income, but it also limits possible gains.
• A collar combines a protective put and a covered call.
• Long straddles and strangles may benefit from a large price movement in either direction.
• Butterfly spreads generally work when you expect the price to remain near a particular level.
• Hedging reduces risk but cannot completely remove it.
• Option premiums and other trading costs can reduce your overall returns.
   

Hedging with options means taking a position that may offset some of the losses in an existing investment.
For example, suppose you own shares and are worried that their price may fall. You may buy a put option that gains value when the share price declines. The profit from the put may partly compensate for the loss on the shares.
However, a hedge does not always create a net-zero result. Its effectiveness depends on factors such as the strike price, option premium, expiry date, and size of the position.
You can also use multi-legged strategies involving two or more options positions. These strategies may limit losses under certain market conditions, but they can also limit profits and involve additional costs.
 

An options contract is a derivative because its value depends on an underlying asset. The underlying asset may be a share, index, currency, or commodity.

An option gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a fixed price within a specified period. This fixed price is known as the strike price.

Options are mainly divided into two types:

• Call option: Gives the buyer the right to buy the underlying asset at the strike price.
• Put option: Gives the buyer the right to sell the underlying asset at the strike price.

For example, a put option may help protect shares that you already own. If the share price falls below the strike price, the put may increase in value and reduce part of your overall loss.

Different options hedging strategies may suit different market expectations and risk levels.

1. Protective put

In a protective put strategy, you buy a put option for an asset that you already own.
If the asset price rises, you may benefit from the increase in its value. If the price falls, the put option may gain value and help limit your loss.
For example, suppose you own a share trading at ₹500 and buy a put option with a strike price of ₹480. If the share price falls sharply, the put gives you the right to sell at ₹480, subject to the contract terms.
The cost of the put premium reduces your overall return. A protective put limits downside risk while generally keeping the upside open.

2. Covered call

A covered call involves selling a call option on an asset that you already own.
You receive a premium for selling the call. This premium provides a limited cushion if the asset price falls, but it does not protect you against a major decline.
If the asset price rises above the strike price, you may have to sell it at the strike price. This means your potential profit is limited even if the market price rises further.
For example, suppose you own a share trading at ₹500 and sell a call with a strike price of ₹550. If the price rises to ₹600, you may still have to sell the share at ₹550 if the option is exercised.

3. Collar

A collar combines a protective put with a covered call. You buy a put option and sell a call option while continuing to own the underlying asset.
The put sets a lower level of protection, while the call places an upper limit on your potential gains. The premium received from selling the call may partly offset the cost of buying the put.
For example, you may buy a put with a strike price below the current market price and sell a call with a higher strike price. Your possible loss and profit are then limited within this range.

4. Straddle and strangle

A long straddle involves buying a call and a put with the same strike price and expiry date.
A long strangle also involves buying a call and a put with the same expiry date, but the options have different strike prices.
These strategies may be useful when you expect a large price movement but do not know whether the price will move up or down. They are not automatically hedges unless they are used to offset the risk of another position.
For example, before a major event, you may expect a sharp price movement without knowing its direction. A straddle or strangle may gain if the movement is large enough to cover the premiums paid.

5. Butterfly spread

A butterfly spread is a multi-legged strategy that generally benefits when the underlying asset finishes near a chosen middle strike price at expiry.
A long call butterfly involves:

• Buying one call at a lower strike price
• Selling two calls at a middle strike price
• Buying one call at a higher strike price

A long put butterfly uses the same structure with put options. The lower and higher strike prices are usually equally spaced from the middle strike, and all options have the same expiry date.
For example, you may buy one option at a ₹480 strike, sell two options at ₹500, and buy one option at ₹520. The strategy generally produces its highest profit if the asset closes near ₹500 at expiry.
Both the maximum profit and maximum loss are limited. However, this is an advanced strategy because it involves four option positions.
 

Option hedging strategies may help protect an investment from sudden market movements without requiring you to sell it immediately.
For example, if you own shares for the long term but expect short-term uncertainty, you may buy put options. The put may reduce some of your loss if the share price falls during that period.
Covered calls may generate premium income, while collars may limit both downside risk and upside gains.
The main purpose of hedging is to control risk rather than guarantee a profit. The protection received depends on the option chosen, its strike price, expiry date, premium, and the movement of the underlying asset.
 

Options hedging may offer the following benefits:

• Reduced risk: Options can help limit the downside risk of an existing or new position. Some strategies also allow you to estimate the maximum possible loss before entering the trade.
• Lower initial payment for buyers: When you buy an option, you generally pay the premium rather than the full value of the underlying asset. However, sellers may need to provide margin and may face significant obligations.
• Defined outcomes: Strategies such as protective puts, collars, and butterfly spreads can help define possible profit and loss levels.
• Opportunity to remain invested: You may continue holding the underlying asset instead of selling it because of short-term market uncertainty.

Hedging does not guarantee higher returns. Its main purpose is to manage risk, and the premium paid may reduce your final profit.

Hedging with options allows you to manage risk while remaining invested in the underlying asset. Instead of immediately selling an investment, you can use an option to reduce the effect of an unfavourable price movement.

• Downside protection: Buying a put option can establish a minimum selling price for the underlying asset, subject to the strike price and premium paid.

  
  

• Upside participation: A protective put allows you to benefit if the asset price rises, although the premium reduces your net return.

  
  

• Flexibility: You can choose different strike prices, expiry dates, and strategies based on your risk tolerance and market expectations.

  
  

• Defined risk: Some strategies allow you to estimate your maximum possible loss before entering the position.

  
  
• Premium income: Selling covered calls may generate income, but it also limits your potential gains and offers only limited downside protection.

Options can provide a balance between risk protection and growth opportunities. However, the effectiveness of the hedge depends on how the strategy is structured.

Hedging with options can help reduce the downside risk of an investment. Strategies such as protective puts, covered calls, collars, straddles, strangles, and butterfly spreads serve different purposes and work under different market conditions.
However, options hedging involves premiums, expiry dates, strike prices, and multiple possible outcomes. It may reduce losses, but it cannot remove all risks or guarantee profits.
Beginners may find multi-legged strategies difficult to understand and manage. Practising with market simulations can help you understand how each strategy behaves before using real money.