February 14, 2016

Options and hedging

Question: Option spreads involves going short and going long to cover the short and is called hedging. I am trying to find a material which can tell me how to calculate the hedge strike.  On website hedge is entered on next strike price where as some websites where spreads are played with deep OTM options position is hedged with a strike price skipping next strike.  eg: for Nifty 6600 instead of hedging with 6500, it is advised to hedge with 6400.  By following this strategy I can get only 50 points as net credit but hedge is away by 200 points. This type of hedge does not help me, in that case why at all hedge is required when we are required to square-off once the index moves down to 6550. Can you help me in understanding requirement of hedging.

S Lokanath

Answer:



It all depends on what view you have of the market and what you are trying to do.

Once you are clear about this, then you will know what you have to do. The hedge will follow from this and will be based on the risk reward ratio.

If you are bullish at current levels (say 7000), then you can
1.Buy 7000 call (98). 

Here hedging is not required as risk is limited (you cannot lose more than what you have already paid). 

If the premium is high and you cannot afford the loss on it, then you either
- buy 7000 call (98) and write 7100 call (57). Max profit is 59 and max loss 41
- buy 7200 call (30) or 7300 call (15)- no hedging here

2.Sell 7000 put (120)

Since profit is limited and risk unlimited, you must hedge this position. Suggested trade is buy 6900 put option (80).

Here max profit is 120-80=40 and max loss is 100-40=60

You can even try something like selling 6500 put and buying 6400 put. Here the profit will be very less and so the loss can be very high. The reason people do these trades is the very low probability of the trade becoming in the money. 

NOTE: you can buy ITM options but never write them.


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