Option hedging strategies: How can they help you?

Introduction 

When you trade stocks, there’s always a chance you could lose money due to unpredictable market changes. However, using special strategies called options hedging can help lower the risk of losing money. 

Option hedging strategies are powerful tools for traders seeking to manage risk in their portfolios. These strategies involve using options contracts to protect against adverse price movements in the underlying assets such as stocks. 

In this article, we will look at different option hedging strategies that can take you a long way in managing your security losses.  

What is an options hedging strategy? 

An options hedging strategy is a risk management technique used by traders to protect their portfolios against potential losses resulting from adverse price movements in the financial markets. 

This strategy involves using options contracts, such as puts and calls, to offset the risks associated with owning underlying assets, such as stocks or commodities. 

By using hedging strategies, you can minimise your exposure to market volatility and uncertainty while preserving potential gains. Now, let’s discuss some common options hedging strategies.

7 best option hedging strategies

Now let us look at some key strategies to help you with the best loss management. 

1. Married put

Under this strategy, a trader buys an asset and put option simultaneously. This ensures that the position is hedged if the underlying asset price drops. It is an ideal strategy to manage the risk of holding a stock. It works similarly to insurance by determining the price floor in case the prices fall tremendously. 

There is a slo a downside to this strategy that the trader will have to let go of the premium paid for the put option in case the stock value does not fall. 

2. Bull call spread

Under bull call spread strategy, the trader buys calls at a specified strike price along with selling a similar number of calls at an increased strike price. The underlying asset and the period of both the call options remain the same. 

This is a vertical spread option selling hedging strategy excellent in cases where the trader is bullish on the asset and expects a moderate price rise. With this strategy in place, the trader benefits by limiting the trade upside and reducing the premium spent. 

3. Bear put spread

Another effective strategy is the bear put spread under which the trader purchases put options at a certain strike rate and sells a similar number of puts at a lower strike rate. The holding period of both the call options remains the same. 

This strategy helps traders with limited losses and limited gains situations. 

4. Naked calls or puts

This strategy comes in handy when traders anticipate a rise or fall in the underlying asset, i.e. the bank nifty option hedging strategy. 

Let us understand the nifty option hedging strategy with example. Suppose, the price of bank nifty goes up. Traders can purchase naked calls to book profits. As against this, when the index begins depreciating, buying a naked put can help secure profits. 

However, keep in mind that it is mandatory to use a stop-loss order to create a safety cushion in case there is a complete price reversal. 

5. Long call butterfly

The long call butterfly strategy involves buying one call option at a lower strike price, selling two call options at a middle strike price, and buying one call option at a higher strike price, all with the same expiration date. This strategy is used when the trader expects the price of the underlying asset to remain relatively stable within a specific range. 

The goal of the long call butterfly is to profit from the slight movement of the underlying asset’s price within the range while limiting potential losses if the price moves outside of the range. This can be called a zero loss option hedging strategy.

6. Short straddle

In a short straddle, you sell both a call and a put option with the same strike price and expiration date. This means you’re assuming that the underlying asset’s price will stay relatively stable. This is one of the best option selling hedging strategies.

You profit if the stock price stays within a certain range until the options expire. However, if the underlying asset’s price moves significantly in either direction, you could suffer losses. It’s a strategy used when you expect low volatility and want to benefit from time decay. 

7. Iron condor

In an Iron Condor, you’re essentially betting that an underlying asset will trade within a specific range. You do this by selling a call spread above the current underlying asset price and selling a put spread below it. By doing this, you collect premiums from both options. 

If the underlying asset stays within your specified range until expiration, you keep the premiums as profit. However, if the stock moves beyond your range, losses are limited due to the protection provided by the options you bought.

Conclusion

Option hedging strategies offer valuable protection against the downside market risk. Implementing hedging techniques safeguards your portfolio from potential losses while still maintaining the opportunity for gains. Consider exploring different hedging strategies to ensure your investments are protected and your financial goals are within reach. To learn more about such concepts, subscribe to StockGro. 

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