Using Options Hedging Strategies during Market Volatility

Imagine you’ve planned a perfect picnic for your family. You’ve got the checkered blanket, the delicious sandwiches, and all the fun games. But there’s one uninvited guest you can’t control: the weather. Suddenly, dark clouds roll in, threatening to rain on your parade. What do you do?

In the world of investing, market volatility can be like that sudden downpour. It can dampen your returns and leave your portfolio feeling soggy. But just like you might pack an umbrella for a picnic, investors have tools to hedge against these downturns: options. This is where risk management in options trading comes into play—strategies that act like your umbrella, helping you protect your investments from unexpected market shifts and allowing you to enjoy a more secure financial journey.

Introduction: Hedging with Options

Think of options like an insurance policy for your investments. They give you the right, but not the obligation, to buy (call option) or sell (put option) a specific stock (or other asset) at a certain price (strike price) by a certain time (expiration date).

While they offer significant profit potential, they can also expose traders to considerable risk, especially during turbulent market conditions. Hedging with options allows traders to manage this risk effectively, ensuring more stability in their investment portfolios.

Top 5 Option Hedging strategies

1. Protective put strategy

Outcome: If the artwork’s value falls to Rs 7,000, you can claim Rs 8,000, minimising your loss. If the value increases, you benefit from owning the artwork while only paying for insurance.
In options trading, a protective put strategy involves buying a put option for an asset you own, allowing you to sell at a set price, protecting against losses while retaining upside potential.

Imagine you own artwork worth Rs 10,000 and buy insurance for it. This policy guarantees you Rs 8,000 if its value drops.

2. Covered call

Imagine you own a rental property that generates Rs 1,000 a month. You’re considering renting it out for a year but want to earn extra income in the meantime.

The hedge: You decide to list the property for short-term rentals at Rs 1,200 a month. If someone rents it, you earn the extra income. However, if you find a long-term tenant, you’ll still receive the Rs 1,000 monthly.
Outcome: If the property is rented short-term, you benefit from the higher rental income. If it isn’t rented and you find a long-term tenant instead, you still have steady income without losing your asset.
In options trading, a covered call strategy involves owning an underlying asset (like your rental property) and selling call options on it. This strategy allows you to earn premium income while potentially selling the asset at a higher price if the call option is exercised, balancing income generation with the risk of selling your asset.

3. Collar strategy

You’re buying a used car for Rs 5,000 but want to avoid high repair costs and value drops.

The hedge: You buy a put option at Rs 4,500 (protects against value loss) and sell a call option at Rs 5,500 (limits profit). Both expire in a year.
Outcome 1: Reliable ride: If the car runs well, you keep it and only lose the option premiums.
Outcome 2: Unexpected repairs: If repairs cost Rs 1,000, you exercise the put option, selling it for Rs 4,500, minimising losses.
Outcome 3: Market boom: If the car’s market value hits Rs 6,000, the call option gets exercised, and you sell for Rs 5,500, missing extra profit but gaining from the sale and call premium.
Explanation: This collar strategy defines profit and loss ranges, protecting against drops (put) while capping gains (call), similar to options trading for managing risk and reward.

4. Straddles

Imagine planning a surprise party for a friend, unsure of their availability. You book two venues—one for Saturday and another for Sunday.

Outcome 1: If your friend can attend Saturday, you use that venue.
Outcome 2: If they’re free Sunday, you celebrate then, ensuring the party happens regardless.
A straddle option strategy involves buying both a call and a put option at the same strike price and expiration. This allows you to profit from significant price movements in either direction, protecting against uncertainty.

5. Spread strategy

Imagine you’re organising a bake sale. You buy cookie ingredients for Rs 2 per batch and sell each for Rs 5, while buying brownie ingredients for Rs 3 and selling them for Rs 6.

Outcome: If cookie sales soar, you enjoy higher profits. If brownie sales lag, cookie profits help offset the costs, reducing overall losses.
In options trading, a spread strategy involves buying and selling options on the same asset at different strike prices or expiration dates, managing risk while allowing for profit potential.

Critical considerations for choosing the right hedging option strategy

Volatility: Assessing market volatility is crucial because higher volatility can lead to greater price fluctuations in options, enhancing the effectiveness of your hedging strategy. This means you can better capitalise on movements that protect your portfolio.
Cost evaluation: It’s essential to consider the cost of hedging, primarily through option premiums. You must weigh these costs against the potential losses you aim to mitigate. A well-structured hedge should provide protection without significantly eroding your returns.
Time horizon: The duration for which you need protection is vital. Short-term hedges might require more frequent monitoring and adjustments, whereas longer-term strategies can offer more stability but may be more susceptible to changing market conditions over time.

Why is hedging with options important?

Risk reduction: Hedging effectively minimises potential losses from adverse market movements, providing a buffer against significant downturns.
Profit protection: It safeguards profits from existing investments by locking in gains, ensuring that favourable outcomes are not jeopardised by market fluctuations.
Stability: Hedging contributes to more predictable financial outcomes, allowing investors to manage their portfolios with greater confidence and reduce the impact of volatility.
Flexibility: Various hedging strategies are available to cater to different risk appetites and market conditions, enabling tailored approaches for individual investors or businesses.
Peace of mind: By mitigating the impact of market volatility, hedging reduces anxiety and allows investors to focus on long-term goals, enhancing overall decision-making and investment strategies.

Conclusion

Hedging is an essential strategy for managing risk, leveraging positions and protecting profits in volatile markets. By carefully considering factors like volatility, cost, and time horizon, investors can choose effective hedging options tailored to their needs.

Ultimately, successful hedging fosters stability and confidence, allowing for a greater focus on long-term growth and investment opportunities.