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Suppose you have XYZ asset in your portfolio, purchased at INR 200, currently valued at INR 180, and, based on the declared quarter results, the stock value is expected suddenly fall more. But according to your research, the company is planning for a change and is about to launch the same, which holds a high chance of a price increase, possibly a 2x or 3x surge in the current price. So, you wish not to sell the stock at a lower price but also to protect the risk (if your prediction goes wrong!)
So, in this jumbled-up situation, Option Trading strategies are your saviour. But before we begin with the option trading details, here’s a quick overview of hedging (a financial strategy that protects against risk).
Hedging is a financial strategy that helps offset risk, protecting yourself against loss and paying a premium for the same.
To begin with, here’s an easy example to explain what hedging is and how it helps wave off the risk!
Rice Farmer and Rice Futures Market -
A farmer plants his winter rice seeds in June-July and plans to sell his harvest in November-December. However, in the six months gap, the farmer is subject to the price risk that it might fall from its current value, INR 80/Kg. While the farmer is planning for maximum profits on his harvest, he also does not want to speculate on the price of rice. So, after planting the seeds, he sells a 6-months (expiration date) futures contract for INR 80/Kg (the strike price).
Six months have passed, and the farmer is now ready to sell his harvest. So, there might be three situations, either the price is the same, has fallen or has increased.
In case of the same price, i.e., INR 80/Kg, the farmer will sell at no profit or loss.
In case of a price fall to INR 70/Kg, the farmer will be on the safe side, selling his harvest at the pre-decided price, INR 80/Kg, preventing the loss of INR 10/Kg.
In case of a price rise, INR 90/Kg, the farmer will sell his lot at the pre-decided future contract price, INR 80, recording a loss of INR 10/Kg.
This is termed hedging, where the rice farmer has limited profits and losses.
Options are trading contracts that give the holder the right to sell or purchase a share when it reaches the strike price or before the contract expiration date. However, options trading only gives the right, not the obligation, to sell or purchase.
Call Options - If you believe that the stock’s market price has a chance to rise from its current level, you will buy a call option.
Put Options - If you believe that the market price of the share will fall below the current price, you will buy a put option.
The risk factor is, therefore, limited when buying put or call options and more when selling the same.
To explain it in easier terms, let’s relate options trading with hedging with an example -
You own 50 stocks of XYZ Company, and bought these stocks at INR 10 each. You are concerned that the price of this stock might fall in future and want to limit your risk. In this case, you will buy a call option at a strike price of INR 8 (which will give you the right and not an obligation) after paying INR 50 premium, with an expiration period of 1 month. Suppose the price fell to INR 5 (recording a loss of INR 250) after 15 days, but since you had a put option at INR 8, you are at INR 150 profit from the current price, recording a total loss of INR 100 only.
Suppose the price rises to INR 20; your profit will be INR 10 x 50 stocks = INR 500 - INR 50 (premium paid), which is INR 450 (total profits).
Options trading with hedging can effectively minimise the risk of potential losses caused by price fluctuations, safeguarding investments.
Options contracts are highly flexible regarding strike prices, expiration dates, and other factors, allowing investors to customise their hedging strategies to their specific needs and goals.
Despite being a risk-averse strategy, options trading with hedging still offers gains if the underlying asset's price moves in the investor's favour, enabling investors to benefit from favourable market conditions.
By hedging with options contracts, investors can limit their losses to a predetermined amount, providing greater certainty and peace of mind in uncertain market conditions.
Compared to other hedging strategies, options trading can be relatively cost-effective, particularly when combined with other methods, making it accessible to many investors.
The options market is highly liquid, which means that options contracts can be easily bought and sold, giving investors greater control over their hedging strategies and facilitating the quick execution of trades.
Financial terms for trading and investment, including hedging, options trading, and options trading with hedging, are quite challenging to understand without clearing out the basics. And trading with fewer or no details about the financial terms can lead to significant losses.
If you want to hedge in options trading, NIWS courses in Jaipur, Delhi and Indore or online trading courses will help you. NIWS is a renowned Stock Market Institute In Jaipur. It offers the best modules for finance, banking, fundamental analysis, technical analysis, wealth management, stock market, portfolio management and other high-paying skills.
For all trading and stock market course in Indore, book your free demo with the experts to excel in your skills.
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