Hedging strategies
Most options-market trading occurs as part of investors’ broader strategies, often involving multiple types of financial instruments. The simplest strategy is a basic hedge, in which an investor purchases an asset and simultaneously buys a put option on that asset, guaranteeing a price at which the asset can be sold if its market price drops. Many strategies are far more complex.
Covering yourself
Writing covered calls or puts is a risk-minimising strategy. Covered means that the writer of the options already owns the underlying. To write a covered put, the writer would have to have a short position in the underlying, having borrowed the asset and then sold it in the expectation that the price would fall before it needed to replace the asset it had borrowed. Suppose, for example, that the writer sells short a share that is trading at $50 and must repay the share three months hence. The writer might then sell puts on the same shares with a strike price of $45. If the share price drops below $45, the writer may lose money on the put but make money by purchasing the shares it shorted at a much lower price. If the share price drops below $50 but stays above $45, the writer earns a premium on the put, which cannot be exercised, as well as making money on the short sale. If the share price rises modestly, the writer will lose money on the short sale of shares, but may earn enough from the premium on the unexercised put to cover that loss. Only a large increase in the share price would cause the writer to lose money. Similarly, writing covered calls involves writing calls on assets the writer owns, or is long on.
Baring all
The opposite strategy is to write naked calls or puts. Naked means that the writer has neither a short nor a long position in the underlying. Naked options offer the potential for higher returns than covered options, as the writer is spared the expense of investing in the underlying. However, writing naked options is a risky activity. The potential loss for the writer of a naked put is the difference between the nominal value of the option at the strike price and zero. The potential loss for the writer of a naked call is unlimited, because, at least in principle, there is no upper limit governing how high
the price of an asset can climb.
Straddling
A straddle positions the investor to benefit either from high price volatility or from low price volatility. A buyer who is said to have a long straddle simultaneously takes put and call options expiring at the same time at the same strike price. For example, if the Deutsche Aktienindex (dax) is now trading at 5,085, an investor might purchase both a May 5,100 dax put and a May 5,100 dax call. The straddle would pay off if the dax either falls or rises substantially. On the downside, for the straddle to be profitable the dax would have to fall far enough below 5,100 that the investor’s gain would more than cover its premiums. On the upside, the dax would have to exceed 5,100 by a wide enough margin to pay the premiums. At any dax value between those two points the investor would lose, even though one of the two options would be in the money. However, the writer who is said to have a short straddle profits as long as the dax remains between those two points; the writer loses only if the index becomes more volatile than anticipated, marking a larger loss or a larger decline.
Spreading
A spread position involves two options on the same underlying, similar to a straddle, except that the put and the call expire at different times or have different strike prices.
Turbo charging
A turbo option involves the purchase of two options with different strike prices on the same side of the market, such as calls at both 55 and 60 or puts at both 40 and 35. This strategy enables the investor to earn dramatically higher returns if the price of the underlying moves far into the money.
Dynamic hedging
Dynamic hedging involves continuously realigning a hedge as the price of the underlying changes. It is widely used by large institutional investors. One of the most popular variants is delta hedging, which attempts to balance an entire portfolio of investments so that its delta is zero. The hedge is said to be dynamic because as the stocks and/or bonds in the portfolio change in value, the options position must also be changed to maintain a delta of zero. The investor must therefore continuously buy or sell options or securities. Critics charge that dynamic hedging destabilises financial markets. Keeping delta at zero often requires the investor to sell the underlying asset at a time when its price is falling or to buy when the price is rising, making market swings sharper. Portfolio insurance, a dynamic heading strategy that purported to protect against declines in the value of stock portfolios, was briefly popular in the 1980s until a key assumption underlying the strategy – that it would always be possible to purchase new options as share prices changed – proved incorrect.
Covering yourself
Writing covered calls or puts is a risk-minimising strategy. Covered means that the writer of the options already owns the underlying. To write a covered put, the writer would have to have a short position in the underlying, having borrowed the asset and then sold it in the expectation that the price would fall before it needed to replace the asset it had borrowed. Suppose, for example, that the writer sells short a share that is trading at $50 and must repay the share three months hence. The writer might then sell puts on the same shares with a strike price of $45. If the share price drops below $45, the writer may lose money on the put but make money by purchasing the shares it shorted at a much lower price. If the share price drops below $50 but stays above $45, the writer earns a premium on the put, which cannot be exercised, as well as making money on the short sale. If the share price rises modestly, the writer will lose money on the short sale of shares, but may earn enough from the premium on the unexercised put to cover that loss. Only a large increase in the share price would cause the writer to lose money. Similarly, writing covered calls involves writing calls on assets the writer owns, or is long on.
Baring all
The opposite strategy is to write naked calls or puts. Naked means that the writer has neither a short nor a long position in the underlying. Naked options offer the potential for higher returns than covered options, as the writer is spared the expense of investing in the underlying. However, writing naked options is a risky activity. The potential loss for the writer of a naked put is the difference between the nominal value of the option at the strike price and zero. The potential loss for the writer of a naked call is unlimited, because, at least in principle, there is no upper limit governing how high
the price of an asset can climb.
Straddling
A straddle positions the investor to benefit either from high price volatility or from low price volatility. A buyer who is said to have a long straddle simultaneously takes put and call options expiring at the same time at the same strike price. For example, if the Deutsche Aktienindex (dax) is now trading at 5,085, an investor might purchase both a May 5,100 dax put and a May 5,100 dax call. The straddle would pay off if the dax either falls or rises substantially. On the downside, for the straddle to be profitable the dax would have to fall far enough below 5,100 that the investor’s gain would more than cover its premiums. On the upside, the dax would have to exceed 5,100 by a wide enough margin to pay the premiums. At any dax value between those two points the investor would lose, even though one of the two options would be in the money. However, the writer who is said to have a short straddle profits as long as the dax remains between those two points; the writer loses only if the index becomes more volatile than anticipated, marking a larger loss or a larger decline.
Spreading
A spread position involves two options on the same underlying, similar to a straddle, except that the put and the call expire at different times or have different strike prices.
Turbo charging
A turbo option involves the purchase of two options with different strike prices on the same side of the market, such as calls at both 55 and 60 or puts at both 40 and 35. This strategy enables the investor to earn dramatically higher returns if the price of the underlying moves far into the money.
Dynamic hedging
Dynamic hedging involves continuously realigning a hedge as the price of the underlying changes. It is widely used by large institutional investors. One of the most popular variants is delta hedging, which attempts to balance an entire portfolio of investments so that its delta is zero. The hedge is said to be dynamic because as the stocks and/or bonds in the portfolio change in value, the options position must also be changed to maintain a delta of zero. The investor must therefore continuously buy or sell options or securities. Critics charge that dynamic hedging destabilises financial markets. Keeping delta at zero often requires the investor to sell the underlying asset at a time when its price is falling or to buy when the price is rising, making market swings sharper. Portfolio insurance, a dynamic heading strategy that purported to protect against declines in the value of stock portfolios, was briefly popular in the 1980s until a key assumption underlying the strategy – that it would always be possible to purchase new options as share prices changed – proved incorrect.
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