How to use Options as a hedge – a guest post

In Chapter 3 of my FREE eBook, I explained why small investors should avoid Futures and Options trading. The odds for success are too low, and the chances of making a loss are too great for my liking.

I belong to the old school of buy-and-hold investors who prefer to get rich slowly. For younger (and smarter) investors, who are not as risk averse as me, Options can be a useful hedging tool. Nishit explains how in this month’s guest post.

----------------------------------------------------------------------------------

Options are much misunderstood and much maligned. They are best used for hedging, and not as a gambling mechanism.

To read the basics of Options one can refer to this older post of mine:

http://money-manthan.blogspot.com/2010/12/introduction-to-options-part-1.html

How do we use Options?

Let us suppose we have a portfolio of stocks and feel that the market is going to take a beating. One approach is to sell our stocks and sit on the cash – which is the safer route. Another approach is to write calls and pocket the premium. E.g., when the Nifty was at 5900, we could have sold the 5900 call option at Rs 142 and pocketed the premium. One would have been at a loss only if the Nifty went above 6050, a gain of about 3%.

To buy options you need to pay a premium, and the seller gets the amount the buyer has paid. He is paid this amount in order to compensate the seller for the risk he is taking - the risk of markets rising.

If the markets rise, your portfolio would also have risen proportionately, provided it had blue chip stocks in it. One could do this month after month and earn extra money while at the same time keeping the portfolio intact. This requires a bit of effort in the sense that one needs to know a bit of technical analysis to understand the support and resistance levels.

What-if Analysis

One could come back and ask: why not buy Puts to hedge? The problem here is that Options are like mangoes, a perishable commodity. If the markets don’t fall, you lose your premium. In case of writing calls, you are getting a net inflow and you would only make less money and lose money if the markets rise more than 3%. If the markets rise more than 3%, then you have got your technicals wrong.

Is the converse true? When we feel the markets are going to rise, can we write Puts?

Writing Puts is one of the most dangerous things to do. Why? Most of the falls are sudden and unexpected. The triggers are something out of the blue. Consider the 9/11 events or some assassination or natural disaster.

Writing Puts and Calls leaves one open to unlimited liabilities. In case of writing calls, one has his or her portfolio as a hedge, but in the case of writing puts there is no hedge really. It should be left to big institutions to do.

Writing Puts can be indulged in, when one has bought another put as a cover. E.g., I know the market is at a support level and will bounce form that level. I write a 5700 put at Rs 150 and buy a 5500 put at Rs 60. My net inflow is Rs 90. The maximum loss I can suffer is if market closes on expiry at 5500, which would render the 5500 put worthless and for the 5700 put I would need to pay Rs 200. I have already got an inflow of Rs 90. So, my net loss would be Rs 110.

Options are great hedging tools but need to be handled very carefully.

----------------------------------------------------------------------------------

(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)