Real-Life Examples of Hedging in Options Trading

Dipendu | Nov. 25, 2024, 8:53 p.m.

Hedging in options trading is a practical way to protect against market volatility or unfavorable price movements. It involves using financial instruments like options to offset potential losses in an existing position. Let’s dive into some real-life scenarios to understand how hedging works in options trading.

1. Protecting a Stock Portfolio with Put Options

Imagine you own 100 shares of a tech company trading at ₹1000 per share. You're concerned about a potential market correction but don’t want to sell your shares.

Hedging Strategy
Buy a put option with a strike price of ₹950, paying a premium of ₹20 per share.

Outcome
-If the stock drops to ₹900, you can sell your shares at ₹950, limiting your losses.
-If the stock rises above ₹950, you lose only the premium (₹20 per share), while enjoying the upside.

This strategy acts as insurance for your portfolio, capping your losses while keeping you exposed to potential gains.

2. Generating Income with Covered Calls

Let’s say you own 500 shares of Bank Nifty ETF, trading at ₹400 per unit. You expect the price to remain stable but want to generate additional income.

Hedging Strategy
Sell call options with a strike price of ₹420, collecting a premium of ₹10 per share.

Outcome
-If the ETF stays below ₹420, you keep the premium as profit.
-If the ETF rises above ₹420, your shares will be sold at ₹420, and you still keep the premium.

This approach is a hedge because the premium offsets potential downside if the stock price falls.

3. Hedging Futures with Options

Assume you’ve taken a long position in Bank Nifty Futures, expecting the index to rise. To protect yourself from unexpected drops:

Hedging Strategy
Buy put options on Bank Nifty at a strike price below the current futures price.

Outcome
-If the index drops, the put options gain value, offsetting losses in your futures position.
-If the index rises, the loss is limited to the cost of the put option premium.

This approach limits your downside risk while keeping your bullish outlook intact

4. Protecting Gains with Collar Strategy

Suppose your stock investment in ABC Ltd. has grown significantly, and the current price is ₹1200 per share. You want to protect your gains while minimizing costs.

Hedging Strategy
Buy a put option at a strike price of ₹1150.
Sell a call option at a strike price of ₹1250 to offset the cost of the put.

Outcome
-If the price drops, the put protects you.
-If the price rises above ₹1250, your gains are capped, but you’ve paid little to nothing for the hedge.
This strategy works well for locking in profits while keeping some upside potential.

5. Managing Market-Wide Risks with Index Options

As a trader with multiple positions in different stocks, you’re concerned about a broad market downturn due to economic uncertainty.

Hedging Strategy
Buy put options on the Nifty 50 Index.

Outcome
-If the market crashes, the put options gain value, offsetting losses in your portfolio.
-If the market rallies, the loss is limited to the premium paid for the puts.

This is a cost-effective way to hedge against systematic risks affecting the entire market.

Hedging with options is a flexible and powerful tool to manage risk while maintaining the potential for profit. Whether you’re protecting a stock portfolio, enhancing income, or shielding against market-wide risks, understanding and applying these real-life strategies can help you trade more confidently.