Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-07-20T15:42:00+05:30
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Introduction

Investors use hedging or Types Of Hedging Strategies to reduce their risk exposure in times when an asset in their portfolio is subjected to a sudden decline in price. When done properly and correctly, the various types of Option Hedging Strategies limit losses and reduce uncertainties while not affecting the rate of return.  

Furthermore, hedging protects the portfolio of an investor against loss, and it even results in reduced returns for the investor. As a result of this, Types Of Hedging Strategies should be engaged to protect the investors against losing money. 

Some investors buy financial instruments, which are known as derivatives. These derivatives, when implemented and executed strategically, restrict the losses at a set level. 

Additionally, hedging against active trading positions using this strategy can help mitigate the overall risks and minimise losses in case of adverse movements in the market. 
 

Options Explained

Options have value only when the strike price is met, which is known as an at-the-money option or when the strike price is exceeded, which is known as an in-the-money option. The options have no fundamental or inherent value before meeting this strike price and are thus worthless before any of this. 

Also, Options are considered cheaper when further away from expiration and the further they are from the money. 

There are two choices accessible to you:

Call Options

Call options huddle the right but not the obligation to purchase an underlying asset. If you feel that the market price will climb from the present/current level, you will buy a call option. On the other hand, if you believe that it will decrease, you will sell a call option. 

The call option is a popular and frequently used technique when one wants to be optimistic about the stock and wants to hedge against a decrease in the price for the short-term of an underlying asset. To implement this option hedging strategy, you must hold a long position in the company. 

You can simultaneously sell/write one call option for equal shares of the same underlying asset or stock. 

This is effective when you are already in a long position in a company's stock and want to enhance your entry/exit price. 

Put Options

Put Options is among other Option Hedging Strategies which allow you to sell the stock at a predetermined price within a particular time frame.

 For example, Jeniffer, an investor, purchases a stock at $10 per share. Jeniffer expects the share prices to rise, but if the prices fall, she will pay a small fee to ensure that she can execute her put option. This will ensure that she can sell the stock later in the year at a higher price. 

An investor with an existing long position in the company's shares. The purpose of choosing this option hedging strategy is to protect the drawback risk if an asset's price falls. Moreover, it is attractive since it allows the investor to limit losses if stock prices fall due to unforeseeable circumstances. 
 

 

Options Hedging steps:

Option Hedging Strategies steps include the following 

●    The first step is to make an account 

●    The second is to trade in by selecting the options market 

●    The next step is to choose from a daily, weekly or monthly option

●    The fourth step is to choose a position size and strike price that allows you to balance exposure 

●    The final step is that the deal must be opened, then monitored and finally closed.
 

How does Hedge Protect the investors?

Option Hedging Strategies help in protecting the investors in the following ways 

●    Risk mitigation 

It helps the investor in managing risks and the investment exposures that they get. Derivatives are used in protecting investors if things do not go in the right direction that the investor expects. 

●    Price clarity 

Individual investors and companies use derivatives to eliminate uncertainties regarding a future commodity or asset prices. By using Option Hedging Strategies, investors can lock in the prices for key/primary goods well in advance before the date of delivery.  

●    Limits losses 

The third way that hedging protects the investor is that it allows the investor to limit their losses to an amount they are comfortable with. The cost of the Hedge limits their upside. However, the investors can be sure that their losses won't aggravate in case of a decline in the price. 

There is another important thing to keep in mind, which is what happens at the time of options expiry. If the price movement goes against the investors, they may sell stocks and the option for maximum loss.

Alternatively, an investor will profit from the put option once the stock price reaches the support level. If the investors are not interested in either of the mentioned options, they can keep buying new choices every month.
 

Conclusion

Option Hedging Strategies have become a vital part of any investor or trader's daily basis activities. It helps them secure profits, improve their point of entry or, at the very minimum, help them in retaining their current position and manage volatility simultaneously.
 
Options hedging strategies require a thorough comprehension of the applications and techniques that are essential for your detailed and complete understanding of the craft of options hedging strategies.   

However, you must be aware of all risks surrounding Option Hedging Strategies and remember the goal isn't to increase or make profits but to protect yourself from suffering any losses. A little diligence and being careful will help in improved Option Hedging Strategies.
 

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