There are many different ways to use options for risk taking and risk mitigation. Below we describe some of the uses of options
Options as a Hedge
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Using Options to hedge an existing portfolio is one of the most common uses. The typical hedge involved buying a Put option. The cost of the option is essentially the “insurance” premium that is paid by the buyer
Say an investor is long 1000 shares of TATAMOTORS at a price of Rs 295 Current market price is Rs 300 and the investor is worried about the downside. They could buy an April (currently about 2 months away) 280 strike Put for Rs 6 per share. Thus they would spend a total of Rs 6000 on the premium. However if Tatamotors fell below 280, the investor would be fully protected as they will have the right to sell the stock at 280. If the stock goes up the investor makes a profit from the appreciation, but loses the premium paid. So the premium is simply the same as an insurance policy premium
Financing the cost of a hedge
Put options on single stocks can be expensive. Thus it is common to reduce the net cost by selling some other option. Typical strategies are:
Selling a Call option. So in the above example, the investor could sell a 330 Call on Tatamotors for approximately Rs 5, reducing the net cost to Rs 1 only. The investor now has a “floor” on Tatamotors at 280, but also has a “cap “ on Tatamotors at 330 Thus this strategy is useful if the investor believes that the upside is somewhat limited or is happy to take profits at the cap level, i.e. 330 anyway