Buy Options to Hedge Risk


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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.

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Buy Options to Hedge Risk

  1. 1. BUY OPTIONS TOHEDGE RISK By www.Options-Trading-
  2. 2. By www.Options-Trading-Education.comIn today’s uncertain worldinvestors look to preservewealth as much as they doto increase their holdings.
  3. 3. By www.Options-Trading-Education.comOptions can be a usefultool for those wishing todo both.
  4. 4. By www.Options-Trading-Education.comA dominant feature ofoptions markets is thatone can buy options tohedge risk.
  5. 5. By www.Options-Trading-Education.comThe Chicago BoardOptions Exchange,CBOE, was founded in1973 as the first U.S.options exchange offeringstandardized, listedoptions.
  6. 6. By www.Options-Trading-Education.comOver the years optionstraders have used theCBOE to speculate onstocks, futures, indexoptions, regular termoptions, LEAPS, andmore.
  7. 7. By www.Options-Trading-Education.comAnd a continual feature oftrading options on theCBOE is that investorscan buy options to hedgerisk.
  8. 8. By www.Options-Trading-Education.comOptions traders enter intosimple call and putcontracts and often useoptions strategies suchas a long straddle inorder to increase theirchances of profit and
  10. 10. By www.Options-Trading-Education.comThere are two basic kindsof options trading.
  11. 11. By www.Options-Trading-Education.comThese are puts and calls.
  12. 12. By www.Options-Trading-Education.comIn the case of a put atrader purchases the rightto sell an asset such as100 shares of a stock at aset price referred to asthe strike price.
  13. 13. By www.Options-Trading-Education.comThe buyer purchases theright to do so but thecontract confers noobligation on him to doso.
  14. 14. By www.Options-Trading-Education.comHe will only execute thecontract if doing so isprofitable.
  15. 15. By www.Options-Trading-Education.comIn the case of a call thebuyer purchases the rightto purchase an assetsuch as 100 shares ofstock at the strike price.
  16. 16. By www.Options-Trading-Education.comAs with a put option thebuyer is under noobligation to execute thecontract and will do soonly if doing so isprofitable.
  17. 17. By www.Options-Trading-Education.comLong term investors aswell as short term optionstraders use calls toguarantee a price for anequity or asset whosevalue they believe willrise.
  18. 18. By www.Options-Trading-Education.comLong term investors aswell as traders purchasesputs on an equity or assetwho price may well fall.
  19. 19. By www.Options-Trading-Education.comBut, what are some realworld examples of howone can buy options tohedge risk?
  20. 20. By www.Options-Trading-Education.comBUYING PUTS AFTER ASTOCK RISES
  21. 21. By www.Options-Trading-Education.comA common situation inwhich an investor will buyoptions to hedge risk iswhen he purchases astock that is rising rapidlyin price.
  22. 22. By www.Options-Trading-Education.comHe believes that thatstock will continue to riseand, therefore, does notwant to sell.
  23. 23. By www.Options-Trading-Education.comHowever, the market isvolatile and the stock maysuffer a big correction ormay simply fall in price.
  24. 24. By www.Options-Trading-Education.comThe trader buys puts on the stock.
  25. 25. By www.Options-Trading-Education.comHe does so as a form of insurance against loss.
  26. 26. By www.Options-Trading-Education.comIf the stock price continues torise he will periodically sell hisputs on the stock in questionand purchase more puts withlater expiration dates,continuing to buy puts so longas he believes that the stockruns the risk of falling.
  27. 27. By www.Options-Trading-Education.comIf the stock does, indeed,fall in price he has twochoices.
  28. 28. By www.Options-Trading-Education.comOne is to go ahead andexecute the contract.
  29. 29. By www.Options-Trading-Education.comHe already has stock.
  30. 30. By www.Options-Trading-Education.comHe can sell at the strikeprice which is greaterthan the current marketprice.
  31. 31. By www.Options-Trading-Education.comHe can then take hiscapital and investelsewhere of he canpurchase the stock againat the lower price andwait for it to rise again.
  32. 32. By www.Options-Trading-Education.comA simpler choice is to sellhis options contracts.
  33. 33. By www.Options-Trading-Education.comThese will have gone upin value to reflect the fallin stock price.
  34. 34. By www.Options-Trading-Education.comHe keeps the stock, atthe lower price, and hisprofit from the optionstrade, which is how onecan buy options to hedgerisk.
  35. 35. For more insights and useful information regarding options and options trading,