Using Options to Manage Risk

In spite of the popularity of trading options for profit, to use them to leverage positions looking to capitalize on expected movements in the underlying security that is being optioned, using options as a hedging mechanism is certainly one of their primary functions.

While options are famous for being one of the riskiest types of positions that a trader can take in the financial markets, and perhaps even the riskiest, depending on the strategy one uses and one’s skill level in trading options, options can also be used to mitigate risk.

There are several ways that options can be used to hedge risk, with the three main categories of this being to hedge other investments, to hedge business interests, and to hedge other options positions. In all cases, one is looking to either purchase an option or sell an option to protect another position, where the intention with the option play is to not take on more risk but to reduce the risk that is already present in their portfolio.

Options used this way consist of the trader purchasing a form of insurance, where if an undesired outcome occurs, a loss in a stock portfolio for instance, the losses incurred will be offset to a degree by the profits made with the option trade.

If the option is not needed, in this case, and your stocks go up, you will lose the option premium but the profit from the stocks will often be greater than the loss of the option premium.

If the stocks trade sideways, and you end up losing the premium and not covering the loss by an increase in the value of your other holdings, this is the downside of this strategy, but the premium lost would be seen as the cost of the insurance that you purchased but did not need, similar to buying insurance against loss and not experiencing the loss.

Options being bought and sold to cover other options positions can be even more important to manage risk, as one’s risk exposure in options can be greater than what one sees when one holds the assets, a stock portfolio for instance, as losses with options can be significantly magnified.

In this case, it may be important to protect oneself against these losses by, for instance, purchasing an option to cover oneself if a certain level of loss on another option is incurred, where the new position would kick in and offset further losses. This is just one example among many of how options can hedge other options positions.

People will also trade options to hedge their business interests, for example a company who may want to protect against big moves in currency fluctuations or commodity prices.

Why Traders May Protect their Portfolio with Options

If someone is looking to hedge their position by taking one that is counter to their current positions, we may wonder if this ever really makes sense, as they could just reduce their exposure instead and accomplish the same thing.

In some cases, that might actually be the better strategy, to reduce the exposure directly, and there’s nothing particularly magical about using options to do this instead. There are some cases though where one may not want to reduce their positions, and others where a strategy such as buying or selling options may provide a more cost effective way to manage this.

Some investors may not be in a position to sell off part of their positions, for example someone under a trading restriction on a stock connected to one’s employment with the company. There may also be some good reasons why one would not want to sell part of their holdings.

While there are several ways to hedge against these moves, with index funds for instance or buying futures, options provide additional flexibility, and this is really the key to options and what makes them so useful in certain situations.

With options, one need not hedge the entire position, as they offer the ability to only hedge certain outcomes, and whenever you buy an option to hedge, this is exactly what you are looking to do.

If an investor for instance has a large exposure to the stock market and wants to hedge not just against any movement against their position but movements of a certain magnitude, this can be achieved easily with options.

In this case, the investor may purchase a put option on the market itself to protect against this market risk, with the strike price at the point where the concern would kick in. Let’s say that the investor was comfortable with a 5% pullback over a period of time but no more. So he or she could purchase a put option at this price, where the option would offset further losses.

The further out the strike price is from the current price, the cheaper the premium tends to be, as you are buying insurance here and you’re insuring less with options further out in price. Time does factor into this as well but this does give people a lot of flexibility as far as only paying for the protection or the hedging that they desire or need.

If one has a lot of different positions, selling part of them can involve a lot higher transaction costs than buying a single option on the S&P 500, for instance, so options can be more economical as far as minimizing transaction costs as well.

So, options can indeed be a viable choice to hedge other assets, in certain situations at least.

Options to Hedge Business Risks

Businesses will often buy and sell futures to help manage their business a little down the road, where prices for certain commodities can be locked in at a future point in time.

These businesses can also purchase options on these futures contracts, and use this as a means to hedge against bigger price movements against them. Futures contracts in themselves are used as hedges by commodity producers and users, although they may not want to enter into these contracts outright and may want to instead hedge against only the bigger risks.

Options do provide this additional flexibility, and this can provide a business with the ability to only hedge certain risks, of their choosing, rather than choosing to hedge against the risk of all price fluctuations during the contract.

They may be producing a commodity and have a positive outlook on its price performance during the life of a futures contract that they could engage in, and not want to do that right now. However, if their outlook is incorrect, they may and probably will want some protection against this.

Waiting until things turn sour to engage the counter futures play may not be that desirable, and instead they may wish to purchase an option on that contract, which will provide them with the hedge they want if the risk emerges. If not, the price of the premium has bought them insurance against the risk.

Businesses who trade in foreign currency may also want to use currency options to protect against a given amount of risk. There are other ways to manage this, both in the cash and futures market, but options provide more options when one does not want the degree of protection that these currency markets provide, and wish to have more targeted protection so to speak.

This is exactly what options provides, a more targeted means of hedging positions or interests beyond the cash or futures markets.

Using Options to Hedge Other Options

One is not limited to just taking one single position in the options market, buying a call or put option, or selling (writing) a call or put option, at a single strike price with a single expiration date, as there are a number of different combinations that option traders use to hedge their various positions.

A lot of options traders do just take one position, but more sophisticated traders, particularly options sellers, will use various strategies to combine their positions. The primary intention here is to hedge one position with one or several other positions, to allow them to profit while managing their risk exposure appropriately.

A simple example of this would be a trader who sells an option on something. Let’s say this is a naked position where the trader does not own the stock.

This is seen as the most risky form of securities trade out there, and the potential losses to the options seller are unlimited. The position may go against the trader to such a degree that their entire account may not be enough to cover the losses.

When you buy an option, your total risk is limited to the premium paid, and the potential profit is unlimited. When you sell options though, the upside is limited to the premium paid and the downside is only limited by the price movement of the underlying security, which is some real risk indeed.

Our trader doesn’t want to experience all that risk though and wants to limit it. So he or she may do that by buying an option at a certain strike price where if the price goes to that level, further losses from the sale of the option will be offset by the option purchase.

This is just one example of how options can be used to hedge other options, and this is a strategy that is also often used by options buyers as well, where they may hold different positions in the same option, at different strike prices or even the same strike price.

While this can be used to speculate, for instance to look to profit from big price movements up or down if you think it will move but are not sure which direction, this can also be used to hedge, protecting other positions while also looking to speculate for instance.

There are many different combinations that can be used with options to achieve a wide variety of objectives, and although options are often used for speculation purposes, options as a means of targeted hedges remains one of its main functions and can be very useful at times.