Numerous investors use derivative securities to hedge their investments against risk. The value of a derivate security is determined from the value of an underlying asset. Some examples of derivate securities include currencies, bonds, interest rates, stocks, and market indexes, among others.
A major type of derivatives security includes options. It is a type of security, which may be purchased or sold, within a specified period at a specified price. This type of security provides the buyer with the right to buy, not the obligation to do so. Options trading are done on securities marketplaces by individual investors, professional traders, and institutional investors, among many others.
There are two types of options, namely, call and put options. The former one gives the holder the right to purchase the said asset at the strike price prior to or on the date of expiration. This is done in exchange for a premium paid to the seller. The value of call options increases as the value of the underlying asset rises. The other option, on the other hand, gives the holder the right to sell the said asset at the strike price on or prior to the date of expiration in exchange for an upfront premium payment. During this time, if the spot price drops, the holder may sell the stock, thereby enjoying a great degree of protection.
Options trading tips to hedge risk
Hedging is a technique used by numerous investors alike in order to lower or eliminate the risk of holding a specified investment position by simply taking another position. Given that options are highly versatile in nature, it becomes a useful instrument as far as hedging is concerned.
You may use options to protect yourself against fluctuations in the price of a share by buying or selling the shares at a pre-decided price for a specified period. By doing so, you may hedge risk successfully.
Following are two options trading strategies that you as an investor may use to reduce your risk.
- Covered Calls
A covered call is a type of options strategy where you may hold a long position in an asset and may sell call options on the specified asset in order to increase your chances of earning greater income from the asset.
Covered calls may be used as a strategy to protect you against small price movements by offering the seller with the proceeds of the transaction.
- Protective Puts
A protective put is used as a hedging strategy by investors wherein the holder of the security buys a ‘put’. This provides the much-needed protection in case the stock price of the particular security was to drop. Such an options strategy may be used when the trader is bullish on the stock but is cautious of the uncertainties in the near future.
You may, therefore, utilize any of the aforementioned options trading strategies based on your attitude towards risk, thereby reducing the risk largely.
