Hedging Futures With Options Strategies – Traders often choose to trade options with little understanding of the options strategies available to them. There are many option strategies that limit risk and increase returns. With a little effort, traders can learn to take advantage of the flexibility and power that stock options can provide.
For calls, one strategy is to simply buy an anaked calloption. You can also structure basiccovered callerbuy-write. This is a very popular strategy because it generates income and reduces some of the risk of holding a single stock for a long time. The trade-off is that you must be willing to sell your shares at a certain price – the short strike price. To execute the strategy, you buy the underlying stock as you normally would and simultaneously write — or sell — a call option on those same stocks.
Hedging Futures With Options Strategies
Let’s say an investor exercises a call option on a stock representing 100 shares of stock per call option. For every 100 shares an investor buys, he would simultaneously sell one call option against him. This strategy is called a covered call because if the stock price rises rapidly, that investor’s short call is covered by the stock’s long position.
Introduction To Hedging
Investors may choose to use this strategy if they have a short-term position in the stock and a neutral opinion about its direction. They may want to generate income by selling the call premium or protect against a potential decline in the stock’s underlying value.
In the profit and loss (P&L) chart above, notice that as the stock price rises, the negative profit and loss from the call is offset by the long stock position. Because the investor receives a premium from selling a call when the stock moves up through the strike price, the premium received allows them to effectively sell their stock at a higher level than the strike price: the strike price plus the premium received. A P&L chart for a covered call is very similar to a short, naked P&L chart.
In a common put strategy, an investor buys an asset—such as a stock—and simultaneously buys put options for the same number of shares. The holder of a put option has the right to sell shares at the strike price, and each contract is worth 100 shares.
An investor may choose to use this strategy as a way of hedging his downside risk while holding the stock. This strategy works much like an insurance policy; sets the price floor in case the share price falls sharply. That is why it is also known as the protective path.
Option Strategy: Long Call
Suppose an investor buys 100 shares and at the same time buys one put option. This strategy can be attractive to this investor because he is protected from the negative consequences if there is a negative change in the share price. At the same time, the investor could participate in any upside opportunity if the stock gains in value. The only downside to this strategy is that if the stock does not fall in value, the investor loses the amount of the premium paid for the put option.
In the profit and loss graph above, the dashed line is the long position of the stock. With a combination of long puts and long stock positions, you can see that losses are limited when the stock price falls. However, the stock may participate in the rise above the premium spent on the sale. The profit and loss chart of a put put is similar to the profit and loss chart of a long call.
In the abull call spread strategy, an investor simultaneously buys calls at a given strike price while simultaneously selling the same number of calls at a higher strike price. Both call options will have the same expiration date and underlying asset.
This type of vertical spread strategy is often used when an investor is optimistic about the underlying asset and expects a modest increase in the asset’s price. By using this strategy, the investor can limit his trading advantage while reducing the net premium consumed (compared to buying a bare call option outright).
Understanding Futures, Options And Other Derivatives
You can see from the profit and loss chart above that this is a bullish strategy. In order for this strategy to be executed properly, the trader must increase the price of the stock in order to make a profit on the trade. The trade-off of a bull call spread is that your upside is limited (although the amount spent on the premium is reduced). When outright calls are expensive, one way to offset the higher premium is to sell higher calls against them. This is how the bull call range is constructed.
A bearish spread strategy is another form of vertical spread. In this strategy, the investor simultaneously buys put options at a certain strike price and sells the same number of put options at a lower strike price. Both options are purchased on the same underlying asset and have the same expiration date. This strategy is used when the trader has bearish sentiments about the underlying asset and expects the price of the asset to fall. The strategy offers limited losses and limited profits.
You can see from the profit and loss chart above that this is a bearish strategy. For this strategy to be successful, the stock price must fall. When using a bear spread, your upside is limited, but your premium spent is reduced. If outright sales contracts are expensive, one way to offset the high premium is to sell lower strike offers against them. This is how the spread with a bear price is put together.
A protective collar strategy is executed by buying an out-of-the-money (OTM) put option and simultaneously writing an OTM call option (with the same expiration) when you already own the underlying asset. This strategy is often used by investors after a long position in a stock has experienced significant gains. This allows investors to hedge against downside, as the long sale helps lock in a potential sale price. However, the trade-off is that they may be forced to sell the stock at a higher price, giving up the opportunity for further gains.
A Guide To Futures & Options Trading Strategies
An example of this strategy is if the investor is long for 100 shares of IBM at $100 as of January 1st. An investor could create a protective collar by selling one IBM March 105 call and simultaneously buying one IBM March 95 put. Trader is protected below $95 until expiration date. The trade-off is that they may be forced to sell their shares at $105 if IBM trades at that price before expiration.
In the profit and loss graph above, you can see that the protective collar is a mixture of a covered call and a long put. This is a neutral trading setup, which means that the investor is protected in case the stock falls. The trade-off is a potentially mandatory sale of the long stock on the short call. However, the investor will likely be happy to do so because he has already experienced gains in the underlying stock.
A straddleoptions strategy occurs when an investor simultaneously buys a call and a put option on the same underlying asset with the same strike price and expiration date. An investor will often use this strategy when they believe that the price of the underlying asset is going to move sharply out of a certain range, but are not sure in which direction that move will go.
In theory, this strategy allows the investor unlimited profits. At the same time, the maximum loss that this investor can experience is limited to the cost of both option contracts combined.
What Are Futures Options?
In the profit and loss graph above, notice that there are two breakeven points. This strategy becomes profitable when the stock makes a big move in one direction or the other. The investor is not interested in which direction the stock moves, only that it is a bigger move than the total premium the investor paid for the structure.
In the longstrangleoptions strategy, an investor buys a call and a put option with different strike prices: an out-of-the-money call and an out-of-the-money put at the same time for the same underlying asset with the same Expiry Date. An investor using this strategy believes that the price of the underlying asset will experience a very large movement, but is not sure in which direction this movement will go.
For example, this strategy could be a bet on news from a company’s earnings release or an event related to the Food and Drug Administration (FDA) approval of a pharmaceutical stock. Losses are limited to the cost – premium spent – of both options. Strangles will almost always be cheaper than straddles because purchased options are out-of-the-money options.
In the profit and loss graph above, notice how the orange line illustrates the two breakeven points. This strategy becomes profitable when the share price, either up or down, moves strongly. The investor is not interested in which direction the stock moves, it only moves enough to put one option or another in the money. It must be more than the total premium paid by the investor for the building.
Market Making With Cross Exchange Hedging Versus Arbitrage
Previous strategies required a combination of the two