Option Hedging Tips: There is a very bitter rule of the stock market. Here, keeping your earned money safe is more important than earning profits. When the market is touching heights, every investor has a smile on his face. But as soon as there is news of any global crisis, threat of war or economic recession, investors lose sleep at night. In such difficult times, when retail investors start selling their shares in panic, then experienced traders and big fund managers make a special plan. This financial weapon is called ‘option hedging’. If you are also troubled by the fear of sudden market fall, then understanding this technique can prove to be very beneficial for you.
Hedging is a protective shield for investment
Just as we get our new car insured to protect it from any possible accident, in the same way the financial insurance taken to protect our purchased shares from a huge fall is called hedging.
In technical language, under option hedging, investors create a position exactly opposite to their current investment by using call or put options. Its simple mathematics is that even if the stock market suddenly falls, the loss in your main portfolio can be easily compensated by the profits from options.
Choose hedging method according to market movements
The process of hedging is not a very complicated mathematics. For this it is only necessary to choose the right time and right strike price. Market experts mainly use three methods:
- Protective Put: This method is considered to be the safest for those investors who already have shares of good companies. Suppose you have shares of a company worth Rs 5 lakh and you fear that the stock will fall due to the upcoming quarterly results. In such a situation, you buy a ‘put option’ of the same company. If the stock falls 10 percent, the price of your put option could rise rapidly by 20-30 percent. This additional profit balances the losses of your shares to a great extent.
- Covered Call: This strategy is effective when the market is trading in a limited range (sideways). In this situation, you sell a ‘call option’ at the upper level of your shares. By selling the call you get a premium amount immediately. If there is no major change in the share price, this premium becomes your additional income.
- Index Hedging: If you have shares of 10 to 15 different companies in your portfolio, then buying a separate put option for each can be a very expensive deal. In this situation, to protect the entire portfolio, investors buy put options on indices like Nifty or Bank Nifty. This is also called ‘broad hedging’ in the financial market.
Don’t make these mistakes while trying to save profits
It is good to protect your investments, but it is equally essential to take some precautions while hedging. First of all, hedging is never free. You have to pay a premium every time you buy an option, which you can think of as the ‘cost of protection’ for your investment.
Moreover, all options have a fixed expiry date. If the market does not fall as per your expectations, the value of your premium paid decreases with the passage of time (in market parlance this is called ‘theta’). Additionally, one should avoid hedging excessively as it can completely wipe out your total profits.
When should common investors adopt this strategy?
In experts’ opinion, common retail investors do not always need to hedge. This strategy should be used mainly when uncertainty (volatility) in the stock market is at its peak. For example, the country’s general budget is about to be presented, the results of general elections are about to come, or a serious situation like an international war is brewing. At these times, the market can move rapidly in any direction, and hedging acts as a strong shield to keep your capital safe.