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10 things to remember when you are hedging your position with options

One of the most common ways of hedging risk in the option market is by using put options. Put options are a right to sell and hence once the premium cost is covered, you are still profitable on the upside. On the downside your risk is limited to the gap between the purchase price and the strike price plus the premium cost. Under no circumstances your losses can cross that limit. Let us look at some hedging strategies using options and how to hedge with options. When we implement option hedging strategies in India there are10 essential points that you need to remember.

10 things to remember when hedging with options

When  you hedge your position with options ensure that the option is not in-the money or at the money. Such options tend to be very expensive and hence may make your breakeven point much harder to achieve. Ideally use an option strike that is slightly out of the money so that you total risk is limited.

Avoid the lure of deep out of the money (OTM) options. They may be visually cheap due to the low premiums but they normally end up worthless. Hence try to keep your put option strike slightly out of the money instead of going for deep OTM put options.

When you buy a put option to hedge your position risk, one thing you need to find out is whether the particular option is underpriced or overpriced. There is a basic Black & Scholes valuation calculator that is in-built in the trading system. Don’t buy options if they are overpriced based on Black and Scholes, They limit your upside profit potential.

Quite often, traders may find the cost of a put option quite prohibitive in their calculation of break even. Hence they also sell a higher call to offset the cost of option partially. This has a downside. While it reduces your cost of buying the put on a net basis, it also limits your profits and hence this strategy of a call spread should only be used if you are moderately bullish, not otherwise.

If the stock falls sharply,  should you book profits on your put option. Actually, that is what you should do. If your equity is part of your long term portfolio, you need to keep churning your options each month. Booking profits helps you to reduce your cost of holding. For example if you bought a stock at Rs.800 and booked a profit of Rs.25 on the put option hedge, then your effective cost of the stock stands reduced to Rs.775. In any month when you get an opportunity you must book profits on your put options.

Keep a tab on liquidity of the put option. Quite often, we find that the put options on individual mid cap stocks can be notoriously illiquid and also the basis risk may be too high. That is a classic buyer’s trap. You may end up incurring a large cost when you try to exit your put option if you don’t buy buyers at realistic levels. Ideally, do this hedging in stocks where there is sufficient liquidity.

Try and exit the put option position ahead of the stock moving beyond 85% of the market wide position limit. Once the market crosses the 90% mark then the stock goes into ban period and fresh futures and options positions are not permitted. While you will still be allowed to close your existing position, the problem is that liquidity can dry up rapidly when the entire pressure is on one side of the transaction.

Keep a tab on transaction costs and taxes. Buying a put option and then squaring it up entails costs in terms of brokerage, GST, STT, stamp duty, turnover tax etc. All these will impact your breakeven point. Also, there is a tax angle to it. When you book profits on your put option, it is taxable as business income even as notional losses on your cash market position are not tax deductible.

How do you hedge stocks that are not in F&O. You obviously cannot get a perfect hedge in such cases. In case of portfolio hedging, you can use the idea of beta hedging. But again, that is an imperfect approximation and does not give you a precise hedge. This is very true of small cap and mid cap stocks that are not available on F&O.

When you are looking at a long term hedge, ensure that closure of the current month put option is immediately replaced with corresponding put option of the next series. If you leave your position open without a hedge for some time, then the entire concept of portfolio protection gets defeated.

There is no royal route to option hedging. However, these 10 rules will go a long way in fine tuning your option hedging process.

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