Question

You are a professional stock trader who specializes in blue chip stocks. You want to hedge your exposure to drops in the market and have chosen to use Dow Jones Index options.

1. If you choose to use call options, should you take a long or short position in the options?
2. If you choose to use put options, should you take a long or short position in the options?
3. Briefly discuss the differences in potential gains and losses between the option positions identified in parts a and b?

4. Which position would you choose to minimize your overall risk? Explain

Answer 1

The trader is long in stock and want to hedge with index option.

If he choose to use call option to hedge i.e. call option to minimise the loss in the event of price goes down then he choose short the call option.

If he choose to use put option to hedge i.e. put option to minimise the loss in the event of price goes down then he choose go long   in the Put option.

If he select short call position then if the price moves downward then the value of call price will also go down and then the trader cover the position at low price.But if price moves upward then the trader will incur loss since the call price will also rise.

If select long in put option then he will be safeguarded against down side risk as price of put moves upward when market go down. But if market goes upside then the trader will incur loss maximum upto the premium paid for put option.

To minimise the overall risk put option should be selected since loss is upto maxmium premium paid but profit is unlimited.