When you dabble in the stock market, it is almost a guarantee that you will get burnt as most expert traders would often say. The market is not a place where you can invest your money and expect a rate of return that is double or triple the cost of capital with minimum effort. While trading can very well be a gamble, there are ways by which an investor can protect his investments from taking a big hit when the market crash. This process is called hedging. However, a real trader with years of experience will tell you that there is no such thing as a risk-free hedge. An investor can off-set the risk, but there will be times when losses cannot be avoided, especially in a volatile market. Hedging can only minimize the loss, but it cannot guarantee absolute protection. In addition, a hedge investment may also work against you because it may also offset potential gains.
Financial Options
Financial options is defined as a derivative security. Options can do three things for an investor. First, options can help generate recurring income. Second, it can offer protection, and lastly, options can offer leverage. Going with the second use of options, it can be used as an effective form of hedge against a falling market to regulate downside losses. In fact, options can offset five different kinds of risks—change in interest rate, change in time, change in volatility, rate of change in price differentials, and price differentials (Weert, 2013).
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There are two kinds of options that can be used in the market—call options and put options. In the case of a call options, it allows the buyer to purchase security for his stocks at the strike price (Thomsett, 2013). With call options, the buyer wants the price of the stock to go up because if it does, he can buy the stocks at a lower price, which is the strike price even if the market price exceeds the strike price. However, the buyer has to take note of the expiration. In other words, this contract is only valid up to a certain period, also known as the expiration date. If there is no movement in the stock price or if the price of the stock drops, the contract will expire worthless and the buyer losses the premium paid on the call option. The risk on the call writer is higher compare to the call buyer.
On the other hand, in put options the buyer wants the stocks to go down while the put writer wants the price of the stock to stay the same or increase in price. Put options give the buyer the right to sell at the strike price (Thomsett, 2013). Thus, if the price of the stocks goes down in value, they can still sell on the agreed price which is higher than the existing price of the strike after it goes down. For example, T stocks (AT&T) was selling at US$30.36. The put writer thinks the price of T shares will go up to US$31.50 sets the strike price at US$31 per share at 100 shares per contract with an expiration date of one week. Unfortunately, the price of T goes down to $28.75 after 4 days, three days before expiration. The buyer can then exercise the contract and sells his share of T at the strike price which is US$31 per share, and the writer has no way to say he does not want to take 100 shares of T at US$31 given that T is only valued at US$28.75, because that was part of the agreement. The contract secures that the writer will end up owning the shares, whether he likes it or not if the puts buyer decided to exercise the contract. In the end, the buyer earned the difference between the strike price and the (current market price + premium paid) multiplied by 100 shares per contract.
References
Thomsett, M. (2013). Getting started in Options. Singapore: John Wiley & Sons Singapore Pte.
Weert, F. (2013). An introduction to options trading. Hoboken, N.J.: Wiley.
