Wednesday, 5 August 2015

Hedging in Option trading

One of the biggest concern for option writers (people who sell options) is how to hedge their positions. As we all know option selling means there is potential of limited profit but potential for unlimited loss is also there.. It becomes all the more important to hedge the positions as nobody wants to take risk of huge losses.
So what can be various possible ways of hedging the positions. Let us say we are talking about selling of Nifty calls or Banknifty calls. If we are selling a call,  there can be three possible ways  of hedging.
  1. Buy Nifty or Banknifty Future
  2. Buy another Nifty/Banknifty call
  3. Sell Nifty / Banknifty Put

In case of A , as we are buying equal number of futures, obviously its a complete hedge for the sold call. We need not be afraid of any upward movement at all. But now the question is , what will happen if market or index starts moving downside. Our sold call will give profit but purchased future will give loss. Both will nullify each others impact upto certain point and after that if index falls further, it will be an unlimited loss in Long Future. So, here upside is fully hedged,but downside is partially hedged.
In case of B, when we buy another call, it is again well hedged on downside as well on upside. But in case of upside, there will be a limited loss which will be equivalent to difference in strike prices of two calls minus net credit received. But still it will be a very limited loss. It will also reduce the overall profit , but the overall position becomes limited loss and limited profit position.
In case of C , when you try to hedge sold call with sold put, this kind of position has dual benefit but dual risk also. If market remains within a particular range, you will get profit from both the sides , but you can also get huge loss on any of the side if market moves sharply to any side. So partial hedging is always there but then you require advance adjustment skills to take care of such  a hedging technique. If you know that, it can be extremely rewarding strategy.
We are educating investors in various hedging techniques. Visit our websites for more details.

#option hedging #strategies #futures #trading options