How does the practice of hedging with options function?

Utilizing options for hedging involves establishing one or more positions to counterbalance the risk associated with an existing trade, which could encompass an ongoing options position, another derivative transaction, or an investment venture.

While the objective of hedging strategies isn't to eliminate all risk completely—since achieving a complete net-zero outcome is nearly unattainable—these strategies can constrain risk to a predetermined extent. The fundamental concept behind hedging is that while one position's value diminishes, another position or multiple positions might generate profits, thereby establishing a net-zero or potentially even a net-profit scenario.

Due to the intricate nature of options, a comprehensive understanding of their mechanics is essential before embarking on hedging activities.

Deciphering Options

Options encompass contracts affording the holder the right, without obligation, to buy or sell an underlying asset at a designated price, referred to as the strike price, on or before a stipulated expiry date.

An option acquires value once the strike price is reached, known as an "at-the-money" option, or exceeded, recognized as an "in-the-money" option. Before this point, the option possesses no intrinsic value and is "out of the money."

Two types of options are available:

Call options: These grant the holder the right, but not the obligation, to purchase an asset. A call option is acquired if there's an anticipation of an increase in market price, while it's sold when a decline is expected.

Put options: These provide the holder the right, but not the obligation, to sell an asset. Put options are purchased in anticipation of a market price decrease, and they're sold if a price rise is foreseen.

Crucially, it's important to bear in mind that when buying call or put options, risk is capped, whereas selling them could entail potentially unlimited risk.

Learn more about options and how to trade them

Put options are often preferred within hedging strategies. By initiating a position to sell the same asset currently owned, potential downside risks can be mitigated. Conversely, if a short position is in play, call options can serve the same purpose—counteracting risk by initiating an opposing, long position.

When employing options for hedging, careful consideration of the trade's premium is necessary. If the premium's cost erases potential hedge returns or leaves the balance at zero, it may not be a viable approach. However, if the premium can be absorbed without nullifying potential returns, or even while generating profits, the strategy merits consideration.

Assets Eligible for Hedging with Options and Rationale

As long as an options market exists, the possibility of establishing an options hedge remains. With our platform, options hedging is feasible for:

Shares

Indices

Forex

Commodities.

Hedging an Equity Portfolio with Share Options

Leveraging options to safeguard against risk within an equity portfolio is a widely embraced tactic. While investors typically focus on longer-term movements, hedging can concurrently yield additional gains and minimize short-term risk. This approach avoids the need to sell shareholdings prematurely, potentially forfeiting long-term profits.

Although many hedging strategies involve establishing positions in markets with minimal correlation, derivatives enable you to assume a short position on the very asset you own.

Conventional short-selling can be intricate, but both long puts and short calls enable you to engage in a position when anticipating market declines. This hedging strategy proves effective if you foresee a substantial decline in the value of your held stock before the option's expiration. Long puts are typically favored in option-based shorting, given the limited risk associated with this approach.

Hedging is feasible with shares in indices like FTSE 100, DOW 30, S&P 500, Nasdaq 100, and Euronext 1001—provided that there exists a tradable options market for the underlying asset. Through options trading via CFDs and spread bets, exposure to options prices is attainable without necessitating direct involvement in the options contract.

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Exemplifying an Equity Options Hedge

Imagine owning 1000 shares of Barclays, each valued at 100p—translating to an overall exposure of $1000. Anticipating a forthcoming news announcement that could potentially prompt market price decline, a decision is made to purchase a put option on Barclays shares via CFDs. Notably, a single options CFD holds equivalent value to 1000 shares of the underlying asset.

Selecting a strike price of 95, the scenario dictates that Barclays shares must dip below 95p for the option to yield profit. To initiate this position, a premium of $25, in addition to a $10 commission, is paid.

Now, if the price of Barclays indeed declines to 90p, the shareholding incurs a loss of $100 ($1000 - $900).

However, the put option turns profitable by $50 ([95 - 90] x 1000), yielding a total profit of $15 post accounting for initial costs.

In summation, the hedge effectively narrows the total loss from $100 to $85.