Question

Explain the motivations behind options hedging. Expand your explanation through various types of options hedging strategies that are available to reduce options hedging costs while able to maximize profit. (limit your answer to be within 500 words)

Answer 1

Ans: First of all we understand what is hedging? Hedging means to reduce the risk exposure of investor, when there is sudden declining in the prices of a stock or asset. Hedging reduces the uncertainity and limit the losses without reducing rate of return.

For an example: if an investor purchases an stock at 10$ and he has a view that price will go up, but he is also a risk averse person so he purchased Put option at 4$ premium having strike price of $8 which hedged his position in case of downfall in the market.

Meaning if price goes beyond 10$ then he will not exercise the option and it costs him $4. But if price goes down to 5$ then he can sell his stock by exercising the option at $8.So Option helped investor in hedging his position into the market.

Following are the option strategies:

1. Cavered Call: In this strategy, investor is already willing to buy the srock at predetermined strike price, so in mean time he can sell call at a premium at that same strike price so that he can earn premium and when the price reaches the estimation then he can go long on that stock and cover his option with his position. Investor can choose this strategy when they have short term position in the stock and neutral position on that stock.

2. Married put: In this strategy investor can simultaneously purchase the stock and a put option to reduce the losses in case of a downward trend in the market. That holder has the right to sell the share at strike price in case prises goes down.

3. Bull Call Spread: Here investor can buys the call at specified strike price and also sell the call at higher price, having same expiration date. He can earn net premium here and get the bet done on bull market.

4. Bear Put Spread: This is smilar to Bull Call Spread, here investor purchase the put at strike price and then sell the same number of put at lower strike price . This is used when trader has estimation of downward trend in the market.