Option Hedging Techniques That Work
One way to think about hedging is to consider it like insurance. When people hedge, they are essentially insuring themselves against an event that could be costly to them. So, although hedging does not prevent the negative event from occurring, it does help to lessen the impact if something does happen.
When hedging is used in the financial sense, it means that an investor has protected him or herself against a loss via a price movement of an asset. And, it is the reason why so many professional options traders have been able to survive and profit over the long term. Therefore, hedging can be considered the placement of “insurance” into a financial portfolio so as to offset certain unfavorable price moves.
In the most basic sense, hedging can be the purchasing of a new stock that will rise as much as the current stocks would fall. Therefore, if an investor owned shares of ABC stock and they were profiting from this investment, but they wanted to protect that profit in the case that ABC shares would fall, the investor could purchase DEF stock which could rise $1 if ABC falls $1.
The truth is, though, it is nearly impossible to hedge stocks with other stocks. It is, however, easy to hedge stocks using stock options. One such way to do so is by using protective puts. In this scenario, an investor would be hedging against a drop in an underlying stock by using put options. Thus, if the underlying stock price were to fall, then the gain in the put option would help to offset the loss from the stock.
Another way to hedge stocks using options is through the use of covered calls. Here the investor would hedge against a slight drop in the price of an underlying stock by selling call options. The premium that the investor receives from the sale of those call options will serve to buffer against the drop in the underlying stock's share price.
A third way to hedge stocks by using options is to use a strategy called a covered call collar. In this case, the investor is hedging against a large drop in the price of the underlying stock by using put options. Here the investor is also at the same time increasing profitability to the upside via the sale of those call options.
In any of these cases of hedging, it is important to understand what exactly the biggest risk is in the portfolio in order to determine the best option strategy with which to hedge the investment properly.