Every investment comes with some risk, which means investors can lose some or all of their money. However, that doesn’t mean that you have to avoid investing, one of the best ways of building wealth; instead, it means that you should have strategies in place to minimize their exposure. One of the best ways of doing this is hedging. Hedging helps protect investors if the price or value of an investment in their portfolio declines. Done right, hedging can limit losses and uncertainty while not affecting the intended rate of return.
Hedging Using Options
There are numerous ways that investors can hedge against risk. Many investors use options for this purpose. Options give traders the right but not the obligation to buy or sell an options contract on or before a specific date at a given price.
When traders use options for hedging, they open multiple positions (buy multiple options contracts) to offset the risk of a single investment. The principle behind doing this is that one position might decline while others rise. In such a scenario, the loss that a trader would otherwise get will be reduced to net zero. In the best-case scenario, the investor might also profit if all or a significant number of their positions yield a profit.
While they are great trading and hedging options, options are complex investment options. It is important to understand how they work before trading, selling options, or using them for hedging.
Types of Options
There are two main types of options you can trade. The first is call options. With this option, the options broker will help you open a contract that allows you to buy an underlying asset. Remember that you are not obligated to go ahead with the purchase, and you can let the contract expire if you are not satisfied with the potential profit you could make.
Traders buy call options when their analysis shows that the price of a commodity is likely to increase before the expiration or execution date.
The other option is put options. These are the opposite of put options and give you the right to sell an underlying asset even though you are not obligated to do so. Traders buy put options when they think the price or value of an asset will decrease in the future.
Traders can also sell their put and call options before the execution date if they find a willing buyer. They sell call options if they think the price will decrease and put options if they think the price will rise. They do this because they would lose money if they bought or sold an options contract when the price has gone against their predictions.
Factors to Consider
Even though options are an excellent tool for hedging, their market is not always completely forgiving so there are several things to consider when buying options. These include:
- Time delay – Options lose some value as their expiration date nears.
- Index drift – The price of the underlying asset will increase over time, causing the value of a put option to decrease.
- Volatility premium – Investors have to pay a downside premium due to price volatility.
Options have become a popular investment option because they have several benefits, including being great for hedging against investment risk. That said, traders should always have risk management strategies that help them avoid or minimize losses regardless of their investment options.
