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How Does Hedging Work in Options Trading?

Definition Of Hedging

Hedging in financial terms is defined as entering transactions that will protect against loss through a compensatory price movement.

Hedging - Introduction

Hedging is what seperates a professional from an amateur trader. Hedging is the reason why so many professionals are able to survive and profit from stock and option trading for decades. So what exactly is hedging? Is hedging something only professionals like Market Makers can do?

Hedging comes from the term "to Hedge" and is any technique designed to reduce or eliminate financial risk. Hedging is the calculated installation of protection and insurance into a portfolio in order to offset any unfavorable moves.

In fact, hedging is not restricted only to financial risks. Hedging is in all aspects of our lives; We buy insurance to hedge against the risk of unexpected medical expenses. We prepare fire extinguishers to hedge against the risk of fire and we sign contracts in business to hedge against the risk of non-performance. Hence, hedging is the art of offsetting risks.

How Do Traders Perform Hedging?

In the simplest form, hedging is simply buying a stock which will rise as much as the current stocks would fall. If you are holding XYZ stocks which is already profiting and you want to protect that profit if XYZ should suddenly fall, then you would buy ABC stock, which rises $1 if XYZ drops $1. In that way, if XYZ company falls by $1, your ABC company stocks would rise by $1, thereby offsetting the loss in XYZ company.

In reality, it is almost impossible to find stocks that move perfectly against another stock, serving as a hedging trade. That is why derivatives like stock options are created. The most classic use of stock options as a hedging tool is in what we call a "Protective Put" or "Married Put" option trading strategy where 1 contract of put options is bought for every 100 shares. Put options rises $1 for every $1 drop in the underlying stock, thereby hedging any loss sustained by the stocks. The cost of buying the put option in this case is similar to buying insurance for your shares. With stock options, even amateur traders can begin hedging a portfolio of stocks against loss.

Hedging Example : Assuming you own 100 shares of QQQQ @ $44 and you wish to hedge against downside risk using stock options. You would buy 1 contract of QQQQ $44 put options which will rise in value by $1 upon expiration for every $1 decline in the price of QQQQ. The price of this "insurance" would be the price you pay for the put options.

Read about How Stocks Can Be Riskier Than Options.

Hedging Stocks Using Stock Options

Hedging a portfolio of stocks is easy and convenient using stock options. Here are some popular methods:

Protective Puts : Hedging against a drop in the underlying stock using put options. If the stock drops, the gain in the put options offsets the loss in the stock.

Covered Calls : Hedging against a small drop in the underlying stock by selling call options. The premium recieved from the sale of call options serves to buffer against a corresponding drop in the underlying stock.

Covered Call Collar : Hedging against a big drop in the underlying stock using put options while simultaneously increasing profitability to upside through the sale of call options.

Hedging In Option Trading

Option traders hedging a portfolio of stock options or hedging an option position in an option trading strategy, needs to consider 4 forms of risk. Directional risk (delta), how directional risk will change with stock price changes (gamma), volatility risk (vega) and time decay risk (theta). Yes, these are the Option Greeks. These risks are factors that influences the value of a stock option and measured by the Option Greeks. Option traders do not normally perform hedging for interest rate risk ( rho) as its impact is very small. Hedging a stock option portfolio requires understanding of what the biggest risk in that portfolio is. If time decay is of concern, then theta neutral hedging should be used. If a drop in the value of the underlying stock is of greatest concern, then delta neutral hedging should be used. All these hedging are done in accordance to the hedge ratio.

Hedging directional risk takes on one of two techniques; Delta Neutral Hedging or Contract Neutral Hedging. Hedging the other 3 forms of risk requires a technique called "Spreading". A popular options strategy that makes use of hedging is the Stock Replacement Strategy.

Why Don't Some Traders Practise Hedging?

Some stock or option traders regard themselves as long term investors who buy and hold for the long term in order to ride an overall long term gain in the stock markets, ignoring short term and mid term fluctuations. These traders completely ignore hedging under the false sense of security that the stock markets will rise over time without fail. While that may be true over the long term of about 20 to 30 years, short term ditches of up to a couple of years do happen and destroys portfolios that are not hedged. Not hedging in this sense is akin to not buying accident insurance just because you always cross the road obeying traffic rules. Does that guarantee that unforeseen circumstances won't happen?

Sometimes, the cost of hedging just doesn't justify the assessed downside risk of a portfolio. We don't live in an ideal world where it costs nothing to execute trades. Hedging involves executing more trades, which costs more money. If a portfolio is assessed to have a $10,000 downside risk, you would not want to incur a hedging cost of $20,000 in order to hedge that portfolio, right? However, if the assessed downside risk is $100,000, a hedging cost of $20,000 would more than justify putting on a hedge.

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