Stock Question and Answer
I primarily trade options and have recently heard some of my trading buddies talk about hedging. What is hedging and how can it help my trading?
Investopedia defines a hedge as follows: “Making an investment to reduce the risk of adverse price movements in an asset.” We could also say that hedging is a technique primarily used to minimize one’s exposure to specific risks. Suppose stock XYZ was trading at $50 and we are long 100 shares. If the stock were to fall in price, we could lose up to $5,000. If we wanted to reduce or minimize this risk, we could enter a separate trade, such as a put option, that increases in value as stock XYZ falls. If the stock drops, although we would be losing on the long stock portion of our trade, we would make money on the put option. In other words, the profit of the put is helping to offset the loss of the stock.
Options are commonly utilized as hedging instruments for long- or short-stock positions. Long-stock positions can be hedged by either buying puts (protective or married put) or shorting calls (covered call). Conversely, short-stock positions can be hedged by either buying calls or shorting puts. If you want to take your understanding of hedging to the next level, I recommend learning more about the Greek Delta. Delta tells you how sensitive your position is to a $1 move in the underlying and can be used to gauge how much of a hedge you need for your existing position.
Within the equities market, most traders who use hedging in their trading tend to focus on hedging adverse moves in the stock price (called Delta hedging). However, within the options market there are other risks involved, such as time decay (Theta risk) and volatility (Vega risk). It is possible to minimize your exposure to time decay and adverse moves in implied volatility. Once you develop a fundamental understanding of Theta and Vega, you can begin to venture into spread trades that mitigate the risks of these two Greeks.