Options Hedging Strategies: Beginner's Guide (2024)

Options hedging is a sophisticated risk management technique employed by investors to protect their portfolios. By utilizing options contracts, investors can create a financial buffer against potential losses in their other investments.

This approach encompasses several key strategies, including the protective put, covered call, collar, and delta hedging. Each of these methods offers unique ways to mitigate risk and potentially enhance returns, allowing investors to tailor their hedging approach to their specific financial goals and market outlook. While options hedging can be complex, it provides a valuable means of safeguarding investments in volatile market conditions.

Here’s what you need to know:

StrategyWhen to UseProsCons
Protective PutProtect against stock price dropsLimits losses, keeps upside potentialCosts money upfront
Covered CallGenerate income, slight downside protectionExtra income, some protectionCaps potential gains
CollarProtect stock from big losses, limit gainsCaps losses and gains, cheaper than just putsLess profit potential
Delta HedgingFor professional tradersReduces price change riskComplex, needs constant adjusting

To get started:

  1. Understand your risk tolerance
  2. Choose the right strategy for your needs
  3. Monitor and adjust your hedges regularly
  4. Use tools like options calculators and risk management software
  5. Keep learning through books, courses, and practice platforms

Remember: Hedging can limit losses but also reduce potential gains. Always consider the costs and trade-offs before implementing a hedging strategy.

Options Basics

Options are tools that let traders buy or sell an asset at a set price within a certain time. Knowing how options work is key for using them to protect investments.

What are options?

Options are contracts tied to assets like stocks or commodities. They offer two main things:

  1. The choice to buy or sell an asset
  2. A set time to make this choice

Call options vs. Put options

There are two main types of options:

Option TypeWhat it doesWhen to use
CallLets you buyYou think prices will go up
PutLets you sellYou think prices will go down

Key terms: Strike price, expiration date, premium

To trade options well, you need to know these terms:

  1. Strike price: The price set in the contract for buying or selling
  2. Expiration date: The last day you can use the option
  3. Premium: What you pay to buy the option

Other important terms:

TermMeaning
At-the-money (ATM)Strike price equals current market price
In-the-money (ITM)For calls: strike price below market price
For puts: strike price above market price
Out-of-the-money (OTM)For calls: strike price above market price
For puts: strike price below market price
Implied volatility (IV)How much the market thinks prices might change

Knowing these basics helps you use options to protect your investments and manage risk.

Hedging Basics

Hedging helps manage risk in finance, especially inoptions trading. It protects investments from possible losses.

What is hedging in finance?

Hedging in finance means taking an opposite position to protect against losses. It’s like insurance:

  • You pay a small fee to avoid big losses
  • Example: Buyingput optionsto protect stocks if the market drops
  • Another example: Using currency futures to protect against exchange rate changes

Hedging aims to reduce losses, not make profits.

Benefits of hedging with options

Options are good for hedging because:

  1. They often cost less than selling the asset
  2. You can adjust them to fit your needs
  3. Your maximum loss is usually just what you paid
  4. You can protect a big investment with a small amount
BenefitWhat it does
Reduces riskLimits losses when markets are bad
Protects investmentsKeeps your overall investment value safe
Lets you stay in the marketYou can keep your investments while lowering risk

Risk management principles

To manage risk well when hedging with options:

  1. Know how much risk you can handle
  2. Make sure your hedge moves opposite to your main investment
  3. Check if the cost of hedging is worth it
  4. Keep an eye on your hedges and change them if needed
  5. Don’t just rely on hedging; spread your investments around

Common Hedging Strategies

Here are some key ways to use options for hedging:

Protective Put

Options Hedging Strategies: Beginner's Guide (1)

This strategy helps protect against losses in a stock you own.

When to use

Use protective puts when:

  • You want to keep your stock but worry about short-term market drops
  • Something might soon hurt the stock price
  • You want to lock in profits but still keep the stock

Pros and cons

GoodBad
Limits lossesCosts money upfront
Can be adjustedMight miss out on some gains
Keeps chance for stock to go upNeed to pick the right strike price

Covered Call

Options Hedging Strategies: Beginner's Guide (2)

This strategy involves sellingcall optionson a stock you own to make extra money.

When to use

Use covered calls when:

  • You think the stock price will stay about the same or go up a little
  • You want to make extra money from your stocks
  • You’re okay with maybe selling your shares at the strike price

Pros and cons

GoodBad
Makes extra moneyLimits how much you can gain
Less risk from price changesMust own the stock
Some protection if price dropsMight miss big gains

Collar Strategy

Options Hedging Strategies: Beginner's Guide (3)

This combines a protective put and a covered call to protect a stock you own.

When to use

Use a collar when:

  • You want to protect your stock from big losses
  • You’re okay with limiting how much you can gain
  • You want to lower the cost of buying protective puts

Pros and cons

GoodBad
Limits losses and gainsCan’t make as much profit
Cheaper way to protectNeed to watch it closely
Can adjust risk and rewardMight have to sell stock early

To set up a collar:

  1. Own at least 100 shares of the stock
  2. Sell a call option above the current stock price
  3. Buy a put option below the current stock price
  4. Make sure both options end on the same day and use the same number of contracts

For example, if you own a $100 stock, you might sell a $105 call and buy a $95 put. This limits your loss to $5 per share and your gain to $5 per share (not counting costs and premiums).

Delta Hedging

This is a complex strategy that tries to keep a neutral position as stock prices change.

When to use

Delta hedging is mostly used by:

  • Professional options traders
  • People managing many different options
  • Those who want to focus on other parts of options while reducing price risk

Pros and cons

GoodBad
Reduces risk from price changesHard to do
Allows focus on other option featuresNeeds constant adjusting
Helps manage risk over timeCan be expensive due to frequent trading

Each strategy has its own good and bad points. Choose based on how much risk you’re comfortable with, what you think the market will do, and what you want to achieve. Make sure you understand these strategies well before using them in real trading.

Advanced Hedging Strategies

These strategies are for traders who know options well. They help manage risk and might boost returns, but they’re complex.

Straddles and Strangles

Options Hedging Strategies: Beginner's Guide (4)

Long Strangle Strategy

These strategies use both call and put options on the same asset at the same time.

When to use

  • For big price moves when you’re not sure which way
  • Around major events like earnings reports

Pros and cons

GoodBad
Make money from big price swingsNeed big price moves to profit
Works for up or down movesCosts a lot to set up
Can make a lot of moneyValue drops over time
You know the most you can loseNeed a bigger move to break even

Butterfly Spreads

Options Hedging Strategies: Beginner's Guide (5)

This strategy aims to profit when prices don’t move much. It uses a mix of call or put options.

When to use

  • When you think prices will stay about the same
  • When option prices are high due to expected big moves
  • Near strong support or resistance price levels

Pros and cons

GoodBad
You know the most you can win or loseCan’t make a lot of money
Costs less than some other strategiesNeed to time the market well
Makes money as time passesHard to set up and watch
Works well when prices don’t move muchPay fees for multiple trades

How to set up a butterfly spread:

  1. Buy one option with a strike price below the current stock price
  2. Sell two options at the current stock price
  3. Buy one option with a strike price above the current stock price

All options should expire on the same day and be for the same number of shares. This strategy works best when the stock price stays near the middle strike price until the options expire.

How to Use Hedging Strategies

Using hedging strategies in options trading takes careful planning and ongoing attention. Here’s how to do it:

Know your risk tolerance

Before you start hedging, you need to understand how much risk you’re okay with. This means:

  • Looking at your money goals and when you need the money
  • Figuring out how much you can lose without big problems
  • Thinking about how much you know about options trading
  • Looking at all your investments together

Remember, hedging often means you might not make as much money, but you also won’t lose as much. Make sure you’re okay with this before you start.

Pick the right strategy

Choosing the best hedging strategy depends on a few things:

  • What you’re trying to protect
  • How the market is doing
  • What you think will happen to the stock or other asset
  • How much the hedge will cost

For example, if you own a stock and want to protect it from going down, you might use a protective put. If you want to make some extra money from a stock you own while also protecting it a bit, you might use a covered call.

Start with simple strategies like protective puts or covered calls before trying harder ones like collars or delta hedging.

Check and update hedges

Hedging isn’t something you can set up and forget about. You need to keep an eye on it:

  • Look at your hedged positions at least once a week, or more if the market is moving a lot
  • Think about why you set up the hedge and if those reasons are still true
  • Keep track of how much the hedge is costing you
  • Be ready to change or close your hedges if the market changes

Remember, options act differently as they get close to expiring. Be ready to roll over or close positions to keep the protection you want.

StrategyWhen to UseProsCons
Protective PutWhen you want to keep a stock but worry about short-term dropsLimits losses, keeps chance for stock to go upCosts money upfront, might miss some gains
Covered CallWhen you think the stock price will stay about the same or go up a littleMakes extra money, some protection if price dropsLimits how much you can gain, must own the stock
CollarWhen you want to protect a stock from big losses but are okay with limiting gainsLimits losses and gains, cheaper than just buying putsCan’t make as much profit, need to watch closely
Delta HedgingFor professional traders managing many optionsReduces risk from price changes, allows focus on other option featuresHard to do, needs constant adjusting, can be expensive

Common Mistakes in Options Hedging

Even skilled traders can make mistakes when hedging with options. Knowing these common errors can help you use hedging better and lower your risks.

Over-hedging

Over-hedging happens when traders use too much protection for their investments. This can cause problems:

  • Less chance to make money
  • More costs from trading
  • Harder to manage investments

To avoid this:

  • Know how much risk you’re okay with
  • Only hedge against clear risks
  • Don’t try to protect against every possible problem

Forgetting about costs

Many traders forget to count the costs of trading when hedging. These costs include:

  • Fees for buying and selling
  • Differences between buy and sell prices
  • Small losses from price changes during trades

Not thinking about these costs can make your hedging less useful. Always add up all costs when deciding if a hedge is worth it. Try to use methods that don’t need lots of trades to keep costs low.

Not understanding the Greeks

The Greeks are tools that help you understand the risks of options. Many traders find them hard to use correctly:

GreekWhat it measuresWhy it’s important
DeltaHow much option price changes when stock price changesHelps manage risk from price moves
GammaHow fast delta changesNeeded for changing hedges over time
ThetaHow time affects option priceImportant for strategies that depend on time
VegaHow changes in stock price swings affect option priceKey for hedges based on price swings

Using these tools wrong can lead to hedges that don’t work well. For example, only looking at delta and not gamma might mean your hedge stops working when the market changes.

To avoid this mistake:

  • Learn what each Greek means and how to use it
  • Use tools that show option prices along with the Greeks
  • Check your hedges often and change them based on how the Greeks change

Options hedging can be tricky, but there are tools to help traders make good choices and handle risks. Here are some key tools for options hedging:

Options calculators

Options calculators help traders figure out option values and possible outcomes. They usually offer:

  • Pricing models
  • Greek calculations
  • Profit/loss scenarios
  • Implied volatility calculations

Here are some popular options calculators:

CalculatorWhat it doesWho it’s for
OIC CalculatorDoes basic math, has learning materialsNew traders
ThinkOrSwimDoes advanced analysis, uses live dataExperienced traders

Risk management software

Risk management software helps traders keep an eye on their risks. These tools often:

  • Look at your whole portfolio
  • Test different market situations
  • Send alerts about big risk changes
  • Let you set up your own risk views

Some well-known risk management tools are:

  1. Bloomberg Risk Analytics
  2. Refinitiv Risk Management
  3. FactSet Portfolio Analytics

These are mostly for big investors and skilled traders with lots of investments.

Learning resources

It’s important to keep learning about options hedging. Here are some good ways to learn more:

  1. Books:
    • “Options as a Strategic Investment” by Lawrence G. McMillan
    • “Option Volatility and Pricing” by Sheldon Natenberg
  2. Online courses:
  3. Webinars and podcasts:
  4. Practice platforms:
    • Paper trading on TD Ameritrade’s thinkorswim
    • Options trading practice tools

Conclusion

Options hedging helps traders protect their investments and manage risk. Here’s what we’ve learned:

  1. Know Your Risks:Before hedging, understand what could harm your investments.
  2. Pick the Right Strategy:Use simple or complex hedging methods based on your needs and market views.
  3. Keep Watching:Check and update your hedges often as markets change.
  4. Weigh Pros and Cons:Remember, hedging can limit losses but also reduce gains.
  5. Use Helpful Tools:Options calculators and learning resources can improve your hedging choices.

Here’s a quick look at some common hedging strategies:

StrategyWhen to UseGood PointsBad Points
Protective PutTo keep a stock but worry about short-term dropsLimits losses, keeps chance for stock to go upCosts money upfront, might miss some gains
Covered CallWhen you think stock price will stay the same or go up a bitMakes extra money, some protection if price dropsCan’t make as much if stock goes up a lot
CollarTo protect a stock from big losses but okay with limiting gainsCaps losses and gains, cheaper than just buying putsLess profit potential, needs close watching

FAQs

How to hedge options for beginners?

New traders can start hedging options by:

  1. Learning the basics of options and trading strategies
  2. Finding risks in their investments
  3. Picking the right option (call or put)
  4. Choosing a good strike price and end date
  5. Watching and changing their hedge as needed

Start with easy strategies like protective puts or covered calls before trying harder ones.

What is an example of an option hedge?

A common option hedge is a protective put. Here’s how it works:

What You HaveWhat You DoWhy You Do It
100 shares of XYZ stock at $50Buy a put option with $45 strike price, ending in 3 monthsProtects against big losses if stock drops below $45, but still lets you gain if price goes up

What are option hedging strategies?

Option hedging strategies help protect investments from losses. Here are some common ones:

StrategyWhat It DoesHow It Works
Protective PutGuards against price dropsBuy put options for stocks you own
Covered CallMakes extra money and gives some protectionSell call options on stocks you own
CollarLimits both losses and gainsUse a protective put and covered call together
Delta HedgingKeeps a neutral positionUse options to balance market moves

These strategies can work for stocks, ETFs, commodities, and currencies, based on what you own and how you want to manage risk.

Options Hedging Strategies: Beginner's Guide (2024)

FAQs

Is hedging with options a good idea? ›

While options can be a robust tool for hedging, they come with their own risks and costs. Therefore, it's crucial to understand these intricacies before using options as a hedging strategy. Inadequate understanding can result in poor decision-making and potential financial loss.

Can you make money by hedging options? ›

Remember, the goal of hedging isn't to make money; it's to protect from losses. The cost of the hedge, whether it is the cost of an option–or lost profits from being on the wrong side of a futures contract–can't be avoided.

What are the three hedging strategies? ›

At a high level, there are three hedge strategy types that companies deploy:
  • Budget hedge to lock in a budget rate.
  • Layering hedge to smooth rate impacts.
  • Year-over-year (YoY) hedge to protect the prior year's rates (50% is likely achievable)

Which option strategy is best for beginners? ›

5 options trading strategies for beginners
  1. Long call. In this option trading strategy, the trader buys a call — referred to as “going long” a call — and expects the stock price to exceed the strike price by expiration. ...
  2. Covered call. ...
  3. Long put. ...
  4. Short put. ...
  5. Married put.
Mar 28, 2024

How do you hedge perfectly? ›

Hedge includes taking two equal but opposite positions in the cash and futures market. In that case, gain and loss in one market is offset by loss and gain in the other market and the hedger's risk exposure will be reduced or eliminated.

What is the best hedging option? ›

Long-Term Put Options Are Cost-Effective

As a rule, long-term put options with a low strike price provide the best hedging value. This is because their cost per market day can be very low. Although they are initially expensive, they are useful for long-term investments.

Is it better to hedge with options or futures? ›

Alternative strategies to consider when hedging

Options: Unlike futures, options provide the right, but not the obligation, to buy or sell an asset at a predetermined price. 10 This can offer more flexibility and potentially lower risk, as the maximum loss is limited to the premium paid for the option.

What is an example of hedging with options? ›

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.

How to make $100 daily with a simple straddle strategy? ›

To use the straddle strategy to make $100 daily, you will need to follow these steps:
  1. Step 1: Choose a Volatile Asset. ...
  2. Step 2: Determine the Strike Price and Expiration Date. ...
  3. Step 3: Buy the Call and Put Options. ...
  4. Step 4: Monitor the Asset's Price Movements. ...
  5. Step 5: Sell Your Options and Collect Your Profit.
May 7, 2023

Which is the best option selling strategy? ›

The Call Ratio Backspread consists of two parts: selling one or more at-the-money or out-of-the-money calls and purchasing two or three calls that are longer in the money than the call that was sold. This strategy is also considered the best option selling strategy.

What is the formula for hedge options? ›

h = ∂C/∂S, this is called the delta of the call option. Thus the proper hedge ratio for the portfolio is the delta of the option.

What is the no loss hedging strategy? ›

The Bank Nifty no loss strategy is designed to protect traders from incurring significant losses while participating in the Bank Nifty index. The core principle of this strategy is to use options to hedge against potential downsides.

Which is the best example of hedging? ›

What is a good hedging example? Some common examples of hedging are using derivatives such as options or futures to mitigate losses, buying an insurance policy against property losses, etc.

How to hedge your portfolio with options? ›

How do you make the hedge work for you effectively? There are two ways to actually do it! Firstly, you can just hold your put option each month and leave it to expiry. Normally, your put option hedging will approximately cost you around 1.30% per month or around 15.6% annualized.

How do you cut a hedge for beginners? ›

If you are new to hedge trimming, it is best to trim lightly at first, then check the shape and take more off if needed. This is particularly advisable when cutting most conifer hedges, as they don't regrow from old wood.

How to hedge put options? ›

Adding extra months to a put option gets cheaper the more times you extend the expiration date. This hedging strategy also creates an opportunity to use what are called calendar spreads. Calendar spreads are created by purchasing a long-term put option and selling a short-term put option at the same strike price.

Top Articles
Latest Posts
Recommended Articles
Article information

Author: Chrissy Homenick

Last Updated:

Views: 6035

Rating: 4.3 / 5 (74 voted)

Reviews: 81% of readers found this page helpful

Author information

Name: Chrissy Homenick

Birthday: 2001-10-22

Address: 611 Kuhn Oval, Feltonbury, NY 02783-3818

Phone: +96619177651654

Job: Mining Representative

Hobby: amateur radio, Sculling, Knife making, Gardening, Watching movies, Gunsmithing, Video gaming

Introduction: My name is Chrissy Homenick, I am a tender, funny, determined, tender, glorious, fancy, enthusiastic person who loves writing and wants to share my knowledge and understanding with you.