Question

Nowadays, the market is predicted to experience a downturn. And most hedging strategies focus on how to minimise losses. Suppose prices are extremely volatile, and you hold a long position in stocks. Design two different strategy involving takinglong position in options to minimise losses and gain potential profits. Justify which is the best one.

Answer 1

1. Married Put- This is a simple strategy. This involves holding a long position in stocks and use put options on the same stock to hedge against the downside risk. You can buy at the money put option (Out of the money put option may lose value if the market doesn’t fall as expected and in the money put would be expensive). At the money put option would gain when the market falls below current levels.

Benefit is that you make money when price falls through put option which can compensate with losses on holding long position in stocks. This comes at a price of premium paid on the put option.

Example: If you hold a stock at cost of $50 and assume its trading at the same price now. You can buy a put for strike price of $50 at a price of $2. If the stock price falls to $40, you would lose $10 on stocks but gain $10 at put options and the net loss incurred is $2 paid for premium.

1. Collar – This strategy involves holding a long position in stocks and buy Put options as well as sell call options for the same stock underlying. The long position in put option would gain when the market falls providing hedge on the long stock at the price of the premium paid on buying the put option. However, you can compensate on the premium paid by receiving premium on writing the call option (Short position).

Example: If you hold a stock at cost of $50 and assume its trading at the same price now. You can buy a put for strike price of $50 at a price of $2. Simultaneously, you can sell a call option for strike price of $50 at a price of $2.

If the stock price falls to $40, you would lose $10 on stocks but gain $10 at put options. The call option will expire worthless (Wont be excercised as the strike price is mote than current market price) but you would get to keep the premium which offsets with premium paid on the put. This strategy has let you hedge the downside risk at no call outflow.

2nd strategy is more cost effective so better than 1st strategy.