We all know that options are a right without the obligation. But the real purpose is not just to take a speculative view on stocks and indices. The real purpose of options is to help you mitigate and manage your risk more precisely. What options provide is the ability to precisely define the risk of your position and also work out your risk under different scenarios. As a result, it is the key to understand how to adopt hedging strategies using options. Let us understand how to risk hedge with options and also let us understand hedging using options examples.
Protecting downside risk on your equity holding.
Let us assume that you are extremely positive on SBI but you also believe that in case of any negative interest rate announcement, SBI stock could take a hit. Even as you hold on to your stock position you simultaneously use options to reduce your risk.
SBI – Bought at Rs.318 | SBI 310 put option bought at Rs.4 | Creation of a hedge on SBISBI PriceOption priceSBI mark to marketSBI Put – MTM3350.25+17-3.753251.25+7-2.753057.25-13+3.2529519.25-23+15.25
In the above instance, the SBI equity market position has been hedged by buying a lower put option. What this put option assures you is that under no circumstance will the loss on your position be more than Rs. 12 (318 – 310 + 4). Due to hedging your maximum loss has been clearly defined and therefore you can work accordingly, knowing fully-well that come what may your total loss on the hedged position will not exceed Rs.12. That is because as the price of SBI falls below Rs.310, your notional losses will be compensated by the profits on the put option. On the upside, your breakeven level for SBI is Rs.322. At that point you cover the cost of the put option and from that point onwards your profits can be unlimited.
How will the hedge work in practice?
That is a more practical question. There are some months when the SBI price will go up and there are some when the SBI price will go down. How do you make the hedge work for you effectively? There are two ways to actually do it!
Firstly, you can just hold your put option each month and leave it to expiry. Normally, your put option hedging will approximately cost you around 1.30% per month or around 15.6% annualized. That means you need to earn at least 15.6% on your SBI cash position each year to just cover the cost of hedging. That is obviously a huge cost to bear and there is no guarantee that SBI will give you more than that. That brings us to the second method of hedging.
Secondly, you can look at a slightly more aggressive approach to hedging. When the price of SBI falls during any month and the put option becomes valuable beyond a point you can book profits on the put option and cash the profits. The only thing you need to remember is to immediately replenish the position with a fresh put option in the next month contract. During a year assume there are 8 up months and 4 down months for SBI. During the down months you realize the profits and during the up months you just led the put option expire worthless. As a result, at the end of 12 months, your cost of hedging may not come down to zero, but it will be substantially lower than the 15.6% hedging cost that you would have paid originally. This aggressive strategy helps you to reduce your cost of hedging and the only thing you must remember is to replenish the hedge.
How to reduce the cost of your hedge by selling call options?
If you are not comfortable with an aggressive approach to hedging, you can use call options to reduce your cost of hedging. Let us rephrase the above case as under:
Buy SBI at Rs.318
Buy SBI 310 put option at Rs.4
Sell SBI 335 call option at Rs.2
The advantage in this scenario is that your net cost of hedging comes down to Rs.2 and your monthly cost of hedging will come down from 1.3% to 0.65%. This makes your hedge a lot more appealing. This strategy works very well when we are of the view that SBI is likely to be range-bound. Selling the higher calls may put a limit on your profits but will surely reduce your cost of hedging. This may have a higher transaction cost and higher margin requirement, but it is suitable for those who are not comfortable with an aggressive approach to hedging portfolio risk.
It is evident that options can be effectively and intelligently used to reduce the risk of your equity stock market trading positions. It is actually simple and very effective!