What is hedging?
Raj Traders started their wholesale trading shop with big plans and dreams in a crowded market. The business started well but what happened next was terrible and unexpected. The shop caught fire, and all the goods and essentials in the shop were destroyed. The lack of insurance cover for both goods and the shop came as a double whammy. Now, the owner was left with no other option except to rebuild from scratch.
Sounds familiar? In the world of trading, many options traders have been in this situation at some point in time. Small and steady profits are wiped out frequently by one big loss or a continuous string of losses. And, you have to start all over again.
While businessmen can cover their risk with insurance, what can options traders do? Well, they can always use options strategies to reduce their losses. Simply put, an investor can deploy an options strategy with a proper hedge in place, which is the art and science of reducing your risk.
What is a hedge in options trading?
In times of uncertainty and volatility in the market, some investors use hedging while placing a trade to reduce their exposure to risk and avoid losses. By deploying an appropriate hedge, the trade remains protected from a sudden jump or a decline in its asset price. In options trading, contracts like calls and puts allow investors a great deal of flexibility in creating a hedge.
Benefits of Hedging
Nothing is more important to options traders than managing and reducing their risk, given the volatile nature of the instrument itself.
1. Limiting losses: Hedging comes at a cost, which is usually in the form of lower profit. However, it certainly reduces the negative impact of an unfavourable outcome compared to not hedging the positions.
2. Lower margin: With the proper hedging in place, losses are minimised, and the traders often get the benefit of lower margins. This helps traders with additional capital, which can be deployed efficiently to maximise returns.
3. Clarity: The best thing a trader can seek is clarity. Once the traders have executed the options strategy, the profit and loss of that strategy are clearly defined. This gives them an edge as they know how much they can lose and gain before entering the trade.
How can I hedge my trades?
Hedging is very simple. It is done by taking an opposite or a contrary position to your primary position while executing your trade. Let’s say you have a bullish view on the Nifty50, and you buy an at-the-money call option for ₹100. This is your primary position. You can hedge this by selling an out-of-the-money call option for ₹50. By selling a call option, you would have reduced your exposure and maximum loss to ₹50, which is the net premium paid.
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