Are you an investor? Are you holding an investment portfolio and worried about the risk of sudden asset price drops? If so, this article is for you. Risk prevention is the solution to protecting your portfolio and minimising losses while maintaining stable profits. Option Alerts will share effective risk prevention measures, from using options to building appropriate strategies. Let’s explore how to control risks and increase the safety of your investment portfolio!
What Is Hedge?
Hedge is a popular concept in finance and investment. It is the application of measures to minimize potential unexpected losses. When you hedge, you protect yourself from adverse events affecting your finances. Though it does not wholly prevent bad events, it will be reduced if an adverse event occurs.
Hedge appears in many areas. For example, when you buy homeowner’s insurance, you protect yourself from risks such as fire, theft, or unforeseen disasters. However, in financial markets, hedging means using financial instruments or market strategies to deal with unfavourable price movements. In other words, investors engage in one investment to hedge the risk of another investment.
How Does Hedge With Option
Hedging with options is a way to protect an investment portfolio from price volatility risk. Investors usually buy securities inversely correlated with vulnerable assets in their portfolios. If the price falls, these securities will move in the opposite direction to reduce risk.
A common hedge strategy with options is put options, which allow you to sell an asset at a fixed price. For example, if you own stocks and are concerned about a price drop, you can purchase a put option and set a predetermined selling price. If the asset’s price falls below this level, you can exercise the option to sell at a fixed price, minimizing your losses. Another approach is selling covered calls on stocks you own, generating income that can help offset minor losses.
Top 3 Common Strategies for Hedging with Options
There are three popular strategies for hedging with options: Protective Put, Covered Call, and Collar Strategy. Each strategy has its own purpose, which is to address specific needs and help investors manage risk more effectively.
Protective Put
Protective Put is a hedging strategy often used when predicting the bearish market but still believing in the long-term growth potential. A put option allows you to sell an asset at a fixed price, limiting losses if the price falls sharply. If the asset price rises, you still benefit from the asset’s value rise; you only lose the premium fee for the option.
For example: You have 100 shares of a stock at $50 per share and buy a put option with a strike price of $45. If the stock price falls to $40, you can exercise the option to sell the stock at $45, minimize your losses.
This strategy is suitable if you believe the stock has long-term growth potential but want to safeguard against unexpected market downturns. Its advantage is that it limits downside risk while retaining upside potential.
Covered Call
The Covered Call strategy is a method that allows investors to earn additional income from their existing assets without having to sell them. If you own shares and sell a call option with a strike price, you will receive the option premium. You keep the shares if the stock price does not exceed the strike price. Conversely, when the stock price exceeds the strike price, you will have to sell the stock at that price, not receiving the excess profit.
This strategy is used when you do not expect the stock price to rise sharply in the short term but still want to earn extra income from the assets. It is openly used when the market is stable or slightly increases. However, the disadvantage of this strategy is that it limits the profit potential if the stock exceeds the option’s strike price and loses the opportunity to benefit from the substantial increase in the asset’s price.
For example: You sell a call option with a strike price of $55 while owning a stock at $50, and you receive the premium from the sale. When the stock price rises above $55, you must sell your shares at that price. However, if the stock price stays below $55, you keep both the premium and your shares.
Collar Strategy
The Collar strategy hedges risk by creating a defined range for an asset’s price. It includes holding the underlying asset, buying a put option and selling a call option. By combining these two strategies, investors can minimize downside risk and receive the option premium.
For example: If you have a stock trading at $100, you buy a put option with a strike price of $90 and sell a call option with a strike price of $110. This strategy ensures that your losses are limited if the stock price falls below $90, and you do not receive any potential gains if the stock price rises above $110. The premium you receive from selling the call option helps to reduce the cost of buying the put option
Though this strategy effectively hedges risk, it limits the potential to benefit from a strong price rise. The Collar strategy is ideal for market high volatility, where protecting against downside risk is a priority.
How to start hedging with options
Choose the asset to hedge: Identify the type of asset you want to protect, such as stocks, ETFs, commodities, currencies, or bonds. This step is crucial for building a strategy that aligns with your investment goals.
Analyst the market: Evaluate market trends and predict price movements of the asset. This will help you decide which options strategy to use for hedging effectiveness.
Open a trading account: Create an account with an options trading site. Locate a good broker with fair rates.
Choose a trading time frame: Choose a time frame you will trade, be it short-term (daily, weekly) or long-term (monthly).
Choose a trading strategy: Depending on your market analysis, choose the most appropriate options and strategy best suited for expected risk and returns, such as covered Calls, protective puts, or Collars.
Execute and monitor your trades: Initiate your trades as planned, monitor market movements, and adjust your strategy when needed to ensure effective portfolio protection.
Key Factors in Hedging with Option
Premium payments: Each of the options carries hedging premiums. You will need to decide whether the cost is worth the benefits before engaging in a hedge.
Strike Price: It must be carefully established; if it is far away from the present market price, then the protection would not be enough, and if it is too near, the hedge may become too expensive.
Market Conditions: Different hedging strategies would yield different results under different prevailing market conditions. Identifying the market to choose the appropriate hedging method.
