How to hedge with options
Options are a popular hedging mechanism as they’re extremely flexible and are limited risk for buyers. Discover how hedging with options works and how to set up your options hedging strategy.
How does hedging with options work?
Hedging with options involves opening a position – or multiple positions – that will offset risk to an existing trade. This could be an existing options position, another derivative trade or an investment.
While hedging strategies can’t entirely remove all your risk – as creating a complete net-zero effect is nearly impossible – they can limit your risk to a known amount. The theory of hedging is that while one position declines in value, the other position (or positions) would make a profit – creating a net zero effect, or even a net profit.
As options are complex instruments, it’s important to understand exactly how they work before you start hedging.
Options are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset once its price reaches a certain level – known as the strike price – at or before an expiry date.
An option only has value once the strike price has been met – known as an at-the-money option – or surpassed – known as an in-the-money option. Prior to this, the option has no intrinsic value, so is out of the money.
There are two types of options available to you:
- Call options – these give the holder the right, but not the obligation, to buy an asset. You’d buy a call option if you believe the market price will rise from its current level, and you’d sell a call option if you think it will fall
- Put options – these give the holder the right, but not the obligation, to sell an asset. You’d buy a put option if you believe the market price will fall from its current level, and you’d sell a put option if you think it will rise
It’s important to remember that your risk is always limited when you’re buying call or put options, but potentially unlimited when selling them.
Put options are more commonly used in hedging strategies, as opening a position to sell the same asset you currently own can help prevent downside risk. However, if you have a short position open, call options strategies would have the same logic behind them – you’d open the opposing position, going long to offset risk.
When hedging using options, you’ll need to consider how much the premium of the trade is. If the cost of opening the position is going to eradicate any of the returns you could make on your hedge, then it’s not worth doing. However, if you could pay the premium and still have a net balance of zero – or even generate a profit – then it’s a strategy worth considering.
What assets can you hedge with options and why?
As long as an options market is available, you can create an options hedge. With us, you can hedge with options on:
Hedging with index options
To manage a large stock portfolio, it can be more efficient to hedge using an index rather than opening multiple positions to hedge each share you own. All you’d need to do is ensure that the index matches the composition of your portfolio in terms of sectors and weighting.
You might also have an ETF index position, which gives you exposure to an entire index without having to buy individual shares. This means that hedging with the corresponding index option is a great way to get one-for-one exposure to your current position.
Example of an index option hedge
You believe that the UK economy will experience a long-term decline, leading the FTSE 100 to fall in value. So, you’ve got a CFD position on the index to fall from its current value of 5800. Your CFD is the equivalent of £10, giving you an exposure of £58,000 (10x5800) for just £1160 – due to the 2% margin on CFDs.
However, an upcoming government announcement is expected to cause a short-term rally on the index. Instead of closing your short-trade and reopening it, you decide to use a daily index call option to hedge the rising prices.
You trade 10 CFDs – worth the equivalent of £10 per point of movement of the underlying – on an option with a strike price of 5880. The option has a premium of 4 points, which would give you a total exposure of £400 (4 x 100).
The price of the index does rise, up to 5900. Your short CFD would have lost you £1000 ([5900 – 5800] x 10). However, your CFD option would be in the money by 20 points, giving you a total of £2000. Once you subtract the premium, you’d have a profit of £1600 on your option.
Your hedge would’ve balanced out the loss to your CFD, and you’d be in profit by £600. Your short index position would still be ready if the market declines as you’re expecting.
If the index had fallen in value instead, you would have lost the £400 premium but would have made profit on your CFD trade that could be used to offset this.
Hedging with currency options
A currency option would give you the right, but not the obligation, to sell a specific currency at a specific price before or on a set expiry date. You might choose to hedge against an existing position on the same forex pair, or against currency exchange risk on an international transaction – such as foreign shares, properties or salaries.
A currency put option is a popular method of protecting yourself against the depreciation of a currency. You’d open an option with a strike price below the current market level, and if the market moves below that put option price, you’d profit on the downturn.
Example of a currency option hedge
Let’s say you’re long on 1000 units of AUD/USD. You opened your position at 7050 ($0.7050), giving you an exposure worth $705 (1000 x 0.750). However, you’re expecting a sharp decline during the day.
So, you decide to hedge your risk, opening a CFD trade on a daily AUD/USD put with a strike price of 6970 and a premium of 3 points. You decide to take a position size of 10 – as each contract is worth $10 per point, you’d have an exposure of $300 ([3 x 10] x $10), or £234.98 in a sterling denominated account at the time of writing.
If, at the end of the day, the price of AUD/USD fell down to 6950, your original position would have made a loss of $100 (7050 – 6950 x 1000). However, your options trade would be in profit by $2000 ([20 x $10] x 10 CFDs). After subtracting your initial cost, you’d have a total profit of $1700 ($2000 - $300).
Not only would you have hedged your loss, but you’d have turned a profit of $1600 ($1700-$100).
Alternatively, if AUD/USD had risen instead, you could let your option expire and would only pay the $300 premium. Some of your profits to your existing position would offset the cost of the options trade.
Hedging with commodity options
Typically the underlying of an options contract will be a futures contract for the commodity, rather than the physical asset. As options can be settled in cash instead of physical delivery, they are a popular means of hedging against commodity risk.
Companies involved in the supply of commodities often hedge with options as it enables them to lock in a price and protect their produce from adverse movements. For example, if a farmer wanted to hedge against their crop of wheat losing its value, they could take out an option to sell their product at the current market price.
This would ensure that regardless of market movements, they have the choice to sell it at the expiry date – but not the obligation. For individual traders and investors, hedging with commodity options can be a great way to protect existing positions on commodity markets or commodity-linked stocks and ETFs.
Example of a commodity options hedge
You own 50 shares in an ETF that tracks the price of gold futures – which you bought at $150 each, giving you a total exposure of £7500. You believe that the price of gold is going to fall from the current market price of $1960 within the next week, which would impact the price of your ETF position.
So, you decide to buy a gold put option with a strike price of 1950. The buy price – or premium – for this option is 7.7 points. As one CFD is the equivalent to an exposure of $100 per point, you’d have a total exposure of $770 (7.7 x $100).
The price of gold subsequently falls, with the underlying settling at $1940 at the time of expiry. Shares in your ETF have also fallen, down to $120, giving you a loss of $1500.
However, your option is ‘in the money’ by 40 points, giving it a value of $4000 (40 points x $100). Factoring in the initial premium paid ($770), your options position would be in profit by $3230 ($4000-$770). So, although your initial ETF investment lost money, you remained in profit by $1730.
Say the price of gold had increased instead, your ETF position would have increased in value and you could let your option expire worthless. You would have lost the $770 you used to open the trade, which could be offset by any profits made.
How to start hedging with options
Start hedging options in just six steps:
- Learn more about options trading
- Create an account
- Choose an options market to trade
- Decide between daily, weekly or monthly options
- Select a strike price and position size that will balance your exposure
- Open, monitor and close your trade
Alternatively, if you don’t feel ready to trade on live options markets, you can practise hedging in a risk-free environment with an IG demo account.
Hedging with options summed up
- Hedging with options involves opening an options position – or multiple positions – that will offset any risk to an existing trade
- If one position declines in value, the other position (or positions) would hopefully turn a profit – balancing each other out or even creating a net profit
- Hedging strategies can’t entirely remove all your risk, but they can help to limit your risk to a known amount
- Your decision about when to hedge using options will largely be based on how much the premium of the trade is. If the cost of opening the position is more than the potential profit, it might not be worth doing
- Long puts tend to be more popular means of hedging as your risk is limited.
- You can use options to hedge shares, forex, indices and commodities
1Individual share options can only be traded over the phone, these contracts are not available online.
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