Table of Contents
Are you in England and curious about what hedging is in options trading? You came to the right place.
In this article, we discuss what hedging is and how it works.
Hedging is part of many trading strategies. It is the act of managing risk by using contracts or other techniques to offset potential losses or gains incurred by a change in the price of an investment.
Investopedia says, “A hedge is also defined as an investment position intended to offset potential losses or gains that a companion investment may incur.”
The term hedging can trace its roots back to 12th century England meaning “the practice of hiding something”. Today it means that you are protecting yourself against risk to your investments from changes in market prices.
Without hedging, you would have to hope that the market goes up and down for you, making money at all times during trading, but with hedging, you can at least protect yourself against the downside risks.
Are you interested in trading?
If you are, there is a chance that you have come across options. Options offer several benefits for those who trade them and reduce risk to a manageable level. One of these benefits is hedging.
Hedging, as stated previously, is an investment strategy where the investor tries to reduce the risk of holding an asset by using another security or contract to counterbalance their position. This way, losses from one position are balanced against gains in the other position.
It allows investors to hedge their positions by selling (writing) options.
An option is any contract that gives the owner the right, but not the obligation, to buy or sell an underlying asset at a set price on or before a specific date.
The profit or loss on an option depends on how close it is to expiration and whether the underlying asset’s price moved higher (for long positions) or lower (for short positions).
You can purchase put options as insurance against losses if you already own an asset. When this happens, you are said to be writing covered calls.
Writing covered calls means collecting premiums for taking on risk by selling (writing) one call per 100 shares.
Writing covered calls reduces your net basis in stock if exercised—that is, upon exercise, the person who exercises buying stock from you at the strike price and selling it to you at the current stock price is essentially writing a covered call for you.
Writing covered calls can also generate extra income if your broker allows this. Many traders like to buy stocks and sell (write) options against them because this limits their risk in case of an adverse move in the market.
Covered calls are one-way investors that use options to hedge positions or reduce risk. Hedging refers to taking steps to ensure profits and minimise losses, such as buying protective puts. Hedging often occurs when there has been a significant change in the market.
For example, if an investor owns shares of company XYZ currently trading at $100/share, he may want to protect himself if the price falls by purchasing a protective put.
A protective put grants you the right to sell 100 shares of the underlying stock at strike price K for a limited time, such as three months. If XYZ is trading below $100/share at expiration, you can choose to exercise your option and sell your shares at $100/share.
How does hedging apply to British options trading?
British options are more complex than their American counterparts.
While you can only exercise American options on the expiration date, British options offer the holder more flexibility in exercising their option to buy or sell a security or financial instrument.
Hedging is a strategy to reduce costs and losses from risk factors you cannot predict ahead of time. When it comes to hedging specific securities such as stocks and shares, investors often turn to oil futures as these tend to fluctuate with changes in stock value.
However, due to its complex nature and stricter regulations for trading, British options trading gives the holder more flexibility in when they can exit a trade and reduces their risk and exposure to future losses.
Suppose you want to know more about trading, such as terms like CFDs and ETFs. Visit our website.