Hedging represents a strategy by which an attempt is made to limit the losses in one position by simultaneously taking a second offsetting position. The offsetting position may be in the same or a different security. In most cases, the hedges are not perfect because they cannot eliminate all losses. Typically, a hedge strategy strives to prevent large losses without significantly reducing the gains.
Very often, options in equities are employed to hedge a long o short position in the underlying common stock. Such options are called covered options in contrast to the uncovered or naked options, discussed earlier.
Hedging a Long Position in Stock
An investor buying a common stock expects that its price would increase. However, there is a risk that the price may in fact fall. In such a case, a hedge could be formed by buying a put i.e., buying the right to sell. Consider an investor who buys a share for Rs. 100. To guard against the risk of loss from a fall in its price, he buys a put for Rs. 16 for an exercise price of, say, Rs. 110.
He would, obviously, exercise the option only if the price of the share were to be less than Rs. 110. Table below gives the profit/loss for some selected values of the share price on maturity of the option. For instance, at a share price of Rs. 70, the put will be exercised and the resulting profit would be Rs. 24, equal to Rs. 110 – Rs. 70, or Rs 40 minus the put premium of Rs. 16. With a loss of Rs. 30 incurred for the reason of holding the share, the net loss equals to Rs. 6.
Hedging a Short Position in Stock
Unlike an investor with a long position in stock, a short seller of stock anticipates a decline in stock price. By shorting the stock now and buying it at a lower price in the future, the investor intends to make a profit. Any price increase can bring losses because of an obligation to purchase at a later date. To minimize the risk involved, the investor can buy a call option with an exercise price equal to or close to the selling price of the stock. Let us suppose, an investor shorts a share at Rs. 100 and buys a call option for Rs. 4 with a strike price of Rs. 105.
Very often, options in equities are employed to hedge a long o short position in the underlying common stock. Such options are called covered options in contrast to the uncovered or naked options, discussed earlier.
Hedging a Long Position in Stock
An investor buying a common stock expects that its price would increase. However, there is a risk that the price may in fact fall. In such a case, a hedge could be formed by buying a put i.e., buying the right to sell. Consider an investor who buys a share for Rs. 100. To guard against the risk of loss from a fall in its price, he buys a put for Rs. 16 for an exercise price of, say, Rs. 110.
He would, obviously, exercise the option only if the price of the share were to be less than Rs. 110. Table below gives the profit/loss for some selected values of the share price on maturity of the option. For instance, at a share price of Rs. 70, the put will be exercised and the resulting profit would be Rs. 24, equal to Rs. 110 – Rs. 70, or Rs 40 minus the put premium of Rs. 16. With a loss of Rs. 30 incurred for the reason of holding the share, the net loss equals to Rs. 6.
Hedging a Short Position in Stock
Unlike an investor with a long position in stock, a short seller of stock anticipates a decline in stock price. By shorting the stock now and buying it at a lower price in the future, the investor intends to make a profit. Any price increase can bring losses because of an obligation to purchase at a later date. To minimize the risk involved, the investor can buy a call option with an exercise price equal to or close to the selling price of the stock. Let us suppose, an investor shorts a share at Rs. 100 and buys a call option for Rs. 4 with a strike price of Rs. 105.