Options Hedging Strategy: How to Use & Benefits

While investors hope for profits, there’s always the risk of loss due to sudden drops in the stock price. This is where the options hedging strategy comes into play. It’s a smart way to manage risks and protect investments from unfavourable price movements. Whether you’re a beginner or an experienced trader, understanding how to hedge with options can help you limit potential losses while staying active in the market.

What is Options Hedging Strategy?

An options hedging strategy is a method used by investors to reduce the risk of losing money on an investment. It involves using options contracts as a form of insurance. These contracts grant you the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time frame.

For example, if you own a stock and fear that its price might fall, you can buy a put option. This gives you the right to sell the stock at a fixed price, even if the market value drops. This helps in limiting potential losses while allowing you to hold onto the investment. 

Common Option Hedging Strategies

Here are some of the most common hedge option trading strategies:

1. Protective Put: This strategy is like buying insurance for your stock. If the stock’s price falls, the put option lets you sell at a fixed price, helping to limit losses.
2. Covered Call: Here, you sell a call option for stocks you own. You earn a premium for writing (selling) the option, but if the stock price rises, your gains are limited as you’d be obligated to sell at the strike price.
3. Collar: A collar combines buying a put option (for protection) and writing a call option (to balance the loss). It limits both losses and potential gains.
4. Straddle and Strangle: These strategies involve buying both call and put options. A straddle has the same strike price for both put and call options, while a strangle uses different strike prices. They’re useful when you expect big price movements but are unsure of the direction.

Benefits of Hedging With Options

Using an options hedging strategy offers several benefits:

• Risk Management: The main benefit is protecting your investment from unfavourable price movements. Even if the stock market becomes volatile, your losses are limited.
• Flexibility: Options offer different choices in terms of strike prices, expiry dates, and types of options. This gives you the ability to choose your strategy according to your needs.
• Profit Potential: While the goal is to reduce risk, you can still profit if the market moves in your favour. The hedge acts only as a safety net, not a complete block to gains.
• Cost-Effective Insurance: Compared to other risk management tools, options can be a cheaper way to protect your investment.
• Confidence in Holding Stocks: Knowing you’ve set a safety net allows you to hold your stocks through short-term dips, especially in uncertain market conditions.

Steps to Start Hedging with Options

Hedging with options is a practical way to protect your investments from market fluctuations. By using options contracts, you can limit potential losses while still participating in market gains. Here’s how to get started:

• Open a Demat and Trading Account

Before you can begin, ensure you have both a Demat account and a trading account. Both accounts are essential for buying and selling options contracts on the stock market. If you don’t have them yet, you can open these accounts through Torus Digital.

• Understand Your Investment Goals and Risks

Assess your current investments and determine what you aim to achieve with hedging. Are you looking to protect against short-term market dips, or are you protecting long-term holdings? Understanding your risk tolerance and investments will help you choose the right hedging strategy.

• Learn the Basics of Options

Familiarise yourself with the two main types of options contracts:

• Call Options: Give you the right to buy an asset at a specific price within a set time.
• Put Options: Give you the right to sell an asset at a fixed price within a set time.

For hedging purposes, put options are commonly used to protect against potential declines in stock prices.

• Choose an Options Market to Trade

Options are available across various markets such as equities, indices, currencies, and commodities. Pick a market that suits your interest and expertise. For beginners, starting with equity or index options can be a good entry point due to their popularity and available resources.

• Decide Between Daily, Weekly or Monthly Options

Options contracts come with different expiry periods. Daily options are short-term and suitable for quick trades, while weekly and monthly options offer more time for your strategy to play out. Your choice should depend on your trading goals and risk appetite.

• Select a Strike Price and Position Size 

The strike price determines the level at which you will buy or sell the asset. Choose a strike price and position size that aligns with your market view and risk tolerance. A balanced approach helps you manage potential losses and avoid overexposure.

• Monitor and Adjust Your Positions

After implementing your hedging strategy, regularly monitor your positions. Market conditions are subject to change, so be prepared to adjust your hedges as needed to maintain protection.

Conclusion

An options hedging strategy is a valuable tool for any investor looking to protect their portfolio. By learning how to use call and put options effectively, you can reduce risk without giving up on growth opportunities. Hedging doesn’t remove all risks, but it gives you more control and peace of mind. Whether you’re protecting gains or preparing for uncertainty, using an appropriate option hedging strategy can make a big difference.

Get started with Torus Digital today! Open a free trading account and begin your trading journey with ease.