Trading options give you the right but not the obligation to buy or sell the underlying security at a set price. You can buy call options if you believe the price of the security will rise. When the call option is exercised, you can buy the stock at the low price and sell it at the higher market price for a profit. You can protect your call option position and your trading principal against an unexpected market downturn by using a hedging strategy.
To hedge call options, you'll need to consider buying an out-of-money put option, shorting the stock or using a credit default swap to be successful.
Research Your Options
First, analyze the strength of the underlying security’s trend and the overall market conditions. Consider your risk tolerance and determine what percentage of the position you want to hedge. For example, if you bought an XYZ call option for $500 and believe the stock price is set to rise, you might be comfortable hedging 25 percent of your position cost. Calculate the amount you need to hedge by multiplying the option cost by the position percentage you want to hedge. For example, the $500 option cost multiplied by 25 percent is $125, which is the amount you want to hedge.
Consider buying an out-of-the-money put option to hedge your call option position. Use the $125 amount you want to hedge as a guide to help you select a put option strike price. Make sure you select a put option with the same expiration date as your call option. For example, if your call option expires the third Friday of the month, select a put option that expires the same day. Be sure to purchase the same number of put options as call options. If you bought three call options, you must purchase three put options to hedge all three positions.
Hedge Your Call Option
Short the stock if the premium for the put option is too high for the amount of hedging it provides. For example, one option controls 100 shares of stock. If the price of XYZ stock is $5 a share, it will cost you $500, which is 100 shares multiplied by $5, to short 100 shares. If the put option premium is $7, it will cost you $700, which is the $7 option premium multiplied by 100 stock shares, to purchase the put option. Since the cost to short the stock is less than the cost of buying a put option, shorting the stock is a more cost-effective way to hedge your call option position.
Use a credit default swap as an inexpensive way to hedge your call option position. Think of a CDS as an insurance policy for your option. It will only pay off if the market moves against your position. A CDS moves in the opposite direction of the market. For example, you would hedge your call position that was in an uptrend by purchasing a CDS that was in a downtrend. Credit default swaps are available through the CME Group and the Intercontinental Exchange.
- Consider hedging your trade by placing a loss limit on your option.
- Make sure the cost of your option hedge doesn’t exceed your potential profit.