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Buy Options to Hedge Risk
In today’s uncertain world investors look to preserve wealth as much as they do to increase their holdings. Options can be a useful tool for those wishing to do both. A dominant feature of options markets is that one can buy options to hedge risk. The Chicago Board Options Exchange, CBOE, was founded in 1973 as the first U.S. options exchange offering standardized, listed options. Over the years options traders have used the CBOE to speculate on stocks, futures, index options, regular term options, LEAPS, and more. And a continual feature of trading options on the CBOE is that investors can buy options to hedge risk. Options traders enter into simple call and put contracts and often use options strategies such as a long straddle in order to increase their chances of profit and hedge their risk.
Puts and Calls
There are two basic kinds of options trading. These are puts and calls. In the case of a put a trader purchases the right to sell an asset such as 100 shares of a stock at a set price referred to as the strike price. The buyer purchases the right to do so but the contract confers no obligation on him to do so. He will only execute the contract if doing so is profitable. In the case of a call the buyer purchases the right to purchase an asset such as 100 shares of stock at the strike price. As with a put option the buyer is under no obligation to execute the contract and will do so only if doing so is profitable. Long term investors as well as short term options traders use calls to guarantee a price for an equity or asset whose value they believe will rise. Long term investors as well as traders purchases puts on an equity or asset who price may well fall. But, what are some real world examples of how one can buy options to hedge risk?
Buying Puts after a Stock Rises
A common situation in which an investor will buy options to hedge risk is when he purchases a stock that is rising rapidly in price. He believes that that stock will continue to rise and, therefore, does not want to sell. However, the market is volatile and the stock may suffer a big correction or may simply fall in price. The trader buys puts on the stock. He does so as a form of insurance against loss. If the stock price continues to rise he will periodically sell his puts on the stock in question and purchase more puts with later expiration dates, continuing to buy puts so long as he believes that the stock runs the risk of falling. If the stock does, indeed, fall in price he has two choices. One is to go ahead and execute the contract. He already has stock. He can sell at the strike price which is greater than the current market price. He can then take his capital and invest elsewhere of he can purchase the stock again at the lower price and wait for it to rise again. A simpler choice is to sell his options contracts. These will have gone up in value to reflect the fall in stock price.