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Hedging versus Leverage in Options Trading
The issue of hedging versus risk in options trading mimics, to a degree, that of conservative versus investing or direct stock trading. To address the issue of hedging versus leverage in options trading we first need to look at buying and selling both puts and calls. A simple options trade goes as follows:
Buy a call contract
In buying a call on a stock, commodity future, or currency the trader purchases the right to buy the equity at the strike (contact) at any time during the term of the contract. He or she is under no obligation to do so and will only execute the contract if doing so is profitable.
Buy a put contract
Buying a put contract gives the trader the option to sell an equity at the strike price if doing so is profitable and confers no obligation to do so.
Sell a call contract
equity to the purchaser at the strike price, no matter how high the price may have gone.
Sell a put contract
In selling a put one receives payment and undertakes the obligation to buy the underlying at the strike price no matter how far it may have fallen.
Purchasing a simple call or put contract gives the trader a degree of leverage in that he or she need only invest the price of the options contract and may reap substantial rewards. In purchasing calls and puts the trader also limits his or her risk to the price of the contract. However, sellers of calls and puts do not give away their money. The prices of calls and puts are set so that, over the long term, a trader can make more money selling options contracts than buying them. There is little leverage in this undertaking despite its profits and little ability to hedge risk with a simple options contract. The matter of hedging versus leverage in options trading has to do with increasingly complex options trading strategies.
Buying and Selling Options Contracts
Often times a trader can execute a profitable option trade in a moderately active market buy both buying and selling options contracts. He hedges his risk but reduces his leverage in the process. An example might be a long butterfly options strategy. This is used when volatility of the underlying equity in the near future is likely to be lower than implied volatility. The trader believes that the implied volatility of an option as derived from financial mathematics is not correct and that the real volatility in the coming days, weeks or months will be lower. The trader purchases and sells contracts as follows, all with the same expiration date. The point of this strategy is to limit or hedge risk in return for which the trader accepts a limit on his leverage or gains in trading. In hedging versus risk in options trading a trader looks to the long term and repeated profits.
A Long Butterfly Options Strategy Consists of the Following...