Option Hedging Strategies: Effective Risk Management with Futures and Options

Hedging is an investment strategy that offsets prospective losses by opposing positions in a related asset. It allows investors to minimise their exposure to risks associated with price fluctuations. In derivatives like futures and options, hedging is crucial in risk management.

This article will explore various option hedging strategies, types of hedging strategies, and hedging with futures examples, etc.

Understanding Futures and Options

Before we explore types of hedging strategies, let’s briefly understand what futures and options are:

1. Futures

• Futures contracts are standardised legal agreements to trade a financial instrument at an agreed price at a specified time.
• They are binding contracts between two parties to trade an asset at a decided price on a future date.
• Traders enter a futures contract to hedge against price risk or speculate on price movements.

2. Options

• Options give buyers the right, not the obligation, to trade an underlying asset at a decided price, called the strike price, within a given timeframe.
• Call options give holders the right to buy the asset, while put options give the right to sell.
• Options buyers pay a premium fee to acquire the options from sellers/writers.

Hedging With Futures

Futures contracts are among the most direct instruments for hedging positions and mitigating risks. Here’s a look at the best hedging strategy for futures:

1. Long Hedge

Investors who own the underlying asset can safeguard against potential price declines by taking short positions in the futures market.

• For example, a jeweller carrying gold inventory can short-sell gold futures contracts on MCX to lock in prices in case spot gold prices fall.
• This long hedge helps limit their downside if gold prices decrease but allows them to benefit if prices go up.

2. Short Hedge

Investors who intend to buy an asset in the future can hedge against price rises by taking a long position in futures.

• For instance, a chocolate manufacturer expecting to buy cocoa can buy cocoa futures to lock in prices.
• This short hedge protects against rising cocoa prices but allows enjoying lower prices if prices drop.

In long-hedge and short-hedge futures hedging strategies, traders can use derivatives to hedge against unfavourable asset price changes, whether they currently own or intend to buy the asset, allowing two-way risk management.

Best Hedging Strategy with Futures Examples

Here is an example of one of the option hedging strategies using futures. Consider an investor holding Reliance Industries (RIL) shares currently trading at ₹2,500.

• He can short-sell RIL futures contracts to hedge against a potential decline in the company’s share price, currently at ₹2,520. They can short-sell RIL hedging strategies using futures as a hedging long position to counter potential decreases.
• If the RIL share price falls to ₹2,300, the short position in RIL futures offsets losses from actual shareholdings.

So, based on your position, futures hedging strategies contracts can help limit risks by taking the opposite trade.

Best Hedging Strategy With Options

While futures hedging strategies contracts lock you into buying/selling the asset, options offer more flexibility:

1. Long Call Option Hedge

Investors who already hold the underlying asset can buy call options on that asset to hedge against price declines while retaining upside potential.

• Consider an hedging with options example: if you own Infosys shares trading at ₹1,500, you can buy ₹1,500 Infosys call option.
• The call option limits the downside if the share price falls below ₹1,500. And if the price rises above ₹1,500, you benefit from the upside.

2. Long Put Option Hedge

If you intend to buy an asset in the future, buying put options on that asset can long hedge against price rises.
Option hedging example, if gold trades at ₹50,000 per 10 grams and you want to buy it in three months, buying a three-month ₹50,000 put option locks in a maximum purchase price.

If gold prices decrease below ₹50,000, you allow the put option to expire and buy gold at lower prevailing prices.

3. Covered Call Strategy

Investors who hold assets can write/sell call options on their holdings to earn option premium income and any gains from the investment.

This covered call strategy boosts yields but limits your upside if the share price rises above the call’s strike price.

Example of Hedging with Index Put Options

Consider an investor holding a diversified portfolio of stocks worth ₹50 lakhs.

• Hedging with options against market risk, he buys 3-month Nifty put options with a strike price closest to the current Nifty index level.
• If the Nifty falls substantially over the next three months, the put options will appreciate in value, acting as a hedge to offset losses from stock holdings.

Options are particularly valuable for investors needing tailored option hedging strategies to protect assets against unexpected market movements.

Hedging Futures With Options

Using futures and options together enables more flexible option hedging strategies. For example, investors who expect prices to rise and buy futures contracts can also buy put options to hedge risk. This put option acts as insurance – if prices fall, the put option value increases to offset the loss from the long futures position.

At the same time, the put option does not limit profits if the original upward price view is correct. This approach balances risk-return payoff for the investor’s portfolio through both futures and options.

Critical Benefits of Hedging With Derivatives

Hedging positions using derivatives like futures and options has several advantages:

• Manages Downside Risk: Hedging limits potential losses from adverse price movements. Though it also caps upside potential, it offers protection.
• Locks in Prices: Derivatives allow investors to lock in prices today for a future purchase or sale, eliminating price uncertainty.
• Portfolio Insurance: Hedging provides portfolio insurance against market risks like volatility, crashes and bear runs.
• Improves Risk-Return Tradeoff: While capping profits from a favourable move in the asset price, hedging reduces risk and allows better risk-adjusted returns.

Best Practices for Hedging With Derivatives

Follow these tips to implement hedging in option trading and futures option hedging strategies effectively:

• Hedge only the quantity you plan to buy or sell – Consider hedging no more than 100% of your exposure.
• Choose liquid derivatives like Nifty, Bank Nifty, Gold, Crude Oil, etc., with sufficient trading volumes for effective hedges.
• Align hedge maturity with your actual requirement to benefit from pricing.
• Before placing hedges, factor in all costs, including brokerage, Securities transaction tax, margins, etc.
• Monitor and adjust/exit hedges to ensure they align with market conditions.

Common Hedging Mistakes

Here are some common mistakes to avoid:

• Hedging in option trading too much or too little relative to your actual exposure.
• Using illiquid contracts with wide bid-ask spreads and high costs.
• Misaligning derivative contract maturity with your requirement timeframe.
• Not factoring in the total costs of placing and maintaining hedges.
• Forgetting to manage hedges actively – “Set and Forget”.

Conclusion

Strategic hedging with futures and options contracts can enable investors to plan asset purchases/sales at known price levels.

While it forgoes windfall profits, hedging protects against adverse price moves and provides valuable insurance against volatility. By following sound hedging principles, traders can intelligently balance risks against returns.
Hedging with derivatives is an essential risk management tool for all investors who want to minimise portfolio risks.

Frequently Asked Questions – FAQs

1. What is hedging in options trading?

Hedging in options trading involves taking an options position that helps offset potential losses from an existing investment or trading position. It aims to reduce the risk exposure of a portfolio.

2. What are the main option hedging strategies and options?

The main option hedging strategies with options are: long call/put to protect long stock positions, short call/put to protect short stock positions, protective puts, covered calls, collars, straddles, strangles, etc.

3. How does a long-call hedge work?

A long-call hedge works by purchasing call options for stocks already owned. This helps limit the downside if the stock price falls, while allowing upside potential if the stock rises above the call strike price.

4. What is a protective put hedge?

A protective put hedge involves buying put options on a stock you already own. This strategy offers downside protection in case the share price falls below the put strike price.

5. What is a covered call option strategy?

A covered call is writing call options on stocks already owned to earn premium income. However, the upside profit potential is limited if the stock rises above the short call’s strike price.

Author: All Content is verified by SMC Global Securities.