by Option
Options are financial instruments that are derivatives based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell depending on the type of contract they hold the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they choose not to.
- Call options allow the holder to buy the asset at a stated price within a specific timeframe.
- Put options allow the holder to sell the asset at a stated price within a specific timeframe.
Each option contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price. Options are typically bought and sold through online or retail brokers.
Options are a versatile financial product. These contracts involve a buyer and a seller, where the buyer pays an options premium for the rights granted by the contract. Each call option has a bullish buyer and a bearish seller, while put options have a bearish buyer and a bullish seller.
Options contracts usually represent 100 shares of the underlying security, and the buyer will pay a premium fee for each contract. For example, if an option has a premium of 35 cents per contract, buying one option would cost $35 ($0.35 x 100 = $35). The premium is partially based on the strike price—the price for buying or selling the security until the expiration date. Another factor in the premium price is the expiration date. Just like with that carton of milk in the refrigerator, the expiration date indicates the day the option contract must be used. The underlying asset will determine the use-by date. For stocks, it is usually the third Friday of the contract’s month.
Traders and investors will buy and sell options for several reasons. Options speculation allows a trader to hold a leveraged position in an asset at a lower cost than buying shares of the asset. Investors will use options to hedge or reduce the risk exposure of their portfolio. In some cases, the option holder can generate income when they buy call options or become an options writer. Options are also one of the most direct ways to invest in oil. For options traders, an option’s daily trading volume and open interest are the two key numbers to watch in order to make the most well-informed investment decisions.
American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date or the exercise date. Exercising means utilizing the right to buy or sell the underlying security.
Hedging
The best way to understand hedging is to think of it as a form of insurance. When people decide to hedge, they are insuring themselves against a negative event’s impact to their finances. This doesn’t prevent all negative events from happening, but something does happen and you’re properly hedged, the impact of the event is reduced.
In practice, hedging occurs almost everywhere, and we see it every day. For example, if you buy homeowner’s insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters.
Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance company a fee every year for coverage.
Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.
Technically, to hedge you would trade make offsetting trades in securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another.
For instance, if you are long shares of XYZ corporation, you can buy a put option to protect you from large downside moves but the option will cost you since you have to pay its premium.
A reduction in risk, therefore, will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you have typically reduced your potential profit, but if the investment loses money, your hedge, if successful, reduces that loss.
Disadvantages of Hedging
Every hedge has a cost, so before you decide to use hedging, you must ask yourself if the benefits received from it justify the expense. Remember, the goal of hedging isn’t to make money but to protect from losses. The cost of the hedge, whether it is the cost of an option or lost profits from being on the wrong side of a futures contract, cannot be avoided. This is the price you pay to avoid uncertainty.
While it’s tempting to compare hedging to insurance, insurance is far more precise. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn’t a perfect science and things can go wrong. Although risk managers are always aiming for the perfect hedge, it is difficult to achieve in practice.
The majority of investors will never trade a derivative contract. In fact, most buy-and-hold investors ignore short-term fluctuation altogether. For these investors, there is little point in engaging in hedging because they let their investments grow with the overall market. So why learn about hedging?
Even if you never hedge for your own portfolio, you should understand how it works, because many big companies and investment funds will hedge in some form. Oil companies, for example, might hedge against the price of oil, while an international mutual fund might hedge against fluctuations in foreign exchange rates. An understanding of hedging will help you to comprehend and analyze these investments.
