Hedging

A risk management strategy used in limiting or offsetting probability of loss from

fluctuations in the prices of underlying securities. In effect, hedging is limiting and
transfer of risk in investment and trading.

Hedging employs various techniques mostly using the derivative tools but,
basically, involves taking equal and opposite positions in two different
markets (such as cash and futures markets). Call Option and a Put option or
futures and option etc in many probabilities. Hedging is used also in
protecting one's capital against effects of inflation.

Derivatives
A derivative is a contract between two or more parties whose value is
based on an agreed-upon underlying financial asset, index or security.
Common underlying instruments include: Market index like Nifty, Stocks,
bonds, commodities, currencies, interest rates etc.
Derivatives are used for speculating and hedging purposes. Speculators seek
to profit from changing prices in the underlying asset, index or security. For
example, a trader may attempt to profit from an anticipated drop in an Nifty
index's price by selling (or going "short") the Nifty futures contract.
Derivatives used as a hedge allow the risks associated with the underlying
asset's price to be transferred between the parties involved in the contract.
Futures contracts, forward contracts, options, swaps and warrants are
common derivatives. However in India only Futures and option are the
available derivative in stock market. A futures contract, for example, is a
derivative because its value is affected by the performance of the underlying
contract. Similarly, a stock option is a derivative because its value is
"derived" from that of the underlying stock. Price Reliance future and
reliance option is derived by price of reliance share price and also its
expected price in short term.
Futures
The party agreeing to buy the underlying asset in the future, the "buyer" of
the contract, is said to be "long", and the party agreeing to sell the asset in
the future, the "seller" of the contract, is said to be "short".[1]

Its a financial contract obligating the buyer to purchase an asset (or the
seller to sell an asset), such as a physical commodity or a financial
instrument, at a predetermined future date and price. Futures contracts
detail the quality and quantity of the underlying asset; they are standardized
to facilitate trading on a futures exchange Example: Nifty future, Infosys
futures etc
Futures can be used either to hedge or to speculate on the price movement
of the underlying asset. For example, a producer of corn could use futures to
lock in a certain price and reduce risk (hedge). On the other hand, anybody
could speculate on the price movement of corn by going long or short using
futures.
Options:
A financial derivative that represents a contract sold by one party (option
writer) to another party (option holder). The contract offers the buyer the
right, but not the obligation, to buy (call) or sell (put) a security or other
financial asset at an agreed-upon price (the strike price) during a certain
period of time or on a specific date (exercise date). There are two types of
options .They are Call Option and a Put Option
Call Option:
Formal contract between an option seller (the optioner) and an option buyer (the
optionee) which gives the optionee the right but not the obligation to buy a
specified contract, financial instrument, property, or security, at a specified price
(called exercise price ) on or before the option's expiration date. Investors who buy
call options believe the price of the underlying asset will go up, and they will be able
to make a high profit from a small (marginal) investment. Opposite of put option.
An agreement that gives an investor the right (but not the obligation) to buy a
stock, bond, commodity, or other instrument at a specified price within a specific
time period.

Put Option:
Put Option gives the optionee the right but not the obligation to sell a
specific contract, financial instrument, property, or security, at a specified
price (called exercise Price) on or before the option's expiration date.
Investors who buy put options believe the price of the underlying asset will

go down and they will be able to purchase (for reselling) another option on
the same asset at a price lower than the current exercise price. Opposite of
call option.
Trading puts and calls provides an excellent way to lock in profits,
maximize gains on short terms stock movements, reduce overall portfolio
risk, and provide additional income streams. Best of all, trading puts and
calls can be profitable in bull markets, bear markets, and sideways markets.
If you are trading stocks but you are not using protective puts, buying calls,
or if you have never sold a covered call option, then you are not making as
much money as you can and you are missing out on some nice profits.

Let`s see some of the myths associated with options trading.

- MYTH 1 - OPTIONS ARE TOO RISKY
Options are too risky if you do not understand them properly. Or if you choose to gamble through
options trading. In fact, options are designed to reduce risk. They are best hedging instruments
available for traders and investors of stock market. If you do not know how to use options, they can be
very risky. So risk does not lie in options but in the knowledge of trader.
- MYTH 2 -

Options Trading Is Only for Professionals with Years of Experience

Options by themselves are not difficult to understand. We are using concepts of options in our routine
transactions such as car insurance, health insurance etc. Only problem is, one needs to find a mentor
who can help in understanding options. The difficult part is that options can be used to formulate
complex trading strategies with flashy names. So its advisable to stick to basic strategies as a
beginner.
- MYTH 3 - IT'S EASY TO PROFIT TRADING OPTIONS
Many believe that its a sure short and easiest way to make money through trading options. But still
there are lots and lots of people who regularly lose money in options. it requires lot of knowledge ,
patience and discipline to make money from trading options and yes .. Easier said than done.

Myth 4: Option Trading Will Be Dead When Normal Market Volatility

Returns
The short answer here isno way. This myth is effectively busted by Wade
Cooperman of trade MONSTER, who told us, The markets been growing in
volatility for a long, long, long time. The reality is that volatility is here to

stay. It will continuethe VIX may go up or down, but volatility is part of

investing.
Myth 5: You Have to Spend Thousands on a Good Options Trading
Education
In the past, it was true that you had to either be in the securities business to
get a good options education, or you had to pay a professional a lot of
money to learn about the options game. All that has changed, however, with
the advent of the Internet and the various trading platforms offered

- MYTH 6 - HIGHLY ABNORMAL GAINS ARE POSSIBLE THROUGH OPTIONS

Every now and then you might be receiving a communication from some tip provider about 100% or
even 1000% returns through options trading and will try to lure you into his subscription. My question
is even if you start with Rs 100 and make that type of profits, nobody can stop you becoming richest
man of the world in very short period. Then why is he selling his secret? Fact is you can consistently
make 4 to 10% returns every month through proper logic and reasoning and this in itself is huge and
qualifies to be abnormal. But 100%, 1000% senseless. If there is a seller there has to be a buyer and if
there is one who benefits from option buying someone who had sold should pay him. Otherwise how
the buyer earns? The seller may have earned in some other derivative or stock if he is a strategic
trader or investor or he might have lost the money if he is gambler, but over all considering only those
2 contracts its a zero sum game, so abnormal profit is not possible on consistent basis.
Trading puts and calls provides an excellent way to lock in profits, maximize gains on short terms
stock movements, reduce overall portfolio risk, and provide additional income streams. Best of all,
trading puts and calls can be profitable in bull markets, bear markets, and sideways markets. If you are
trading stocks but you are not using protective puts, buying calls, or if you have never sold a covered
call option, then you are not making as much money as you can and you are missing out on some nice
profits.
Three things to take note of before trading in option strategies
1) High liquidity should be there always as entry and exit for trade should not cost more due to gap in
buyer price and seller price
2) Should not be easily manipulative
3) ROI should be good after considering the exposure and buffer amount

Option Strategies:

1) The bull call spread option trading strategy is employed when the
options trader thinks that the price of the underlying asset will go up
moderately in the near term.
Bull call spreads can be implemented by buying an at-the-money call option
while simultaneously writing a higher striking out-of-the-money call option of
the same underlying security and the same expiration month.
Bull Call Spread Construction
Buy 1 ITM Call
Sell 1 OTM Call

By shorting the out-of-the-money call, the options trader reduces the cost of
establishing the bullish position but forgoes the chance of making a large
profit in the event that the underlying asset price skyrockets. The bull call
spread option strategy is also known as the bull call debit spread as a debit is
taken upon entering the trade.

Bull Call Spread Payoff Diagram

Limited Upside profits

Maximum gain is reached for the bull call spread options strategy when the
stock price move above the higher strike price of the two calls and it is equal
to the difference between the strike price of the two call options minus the
initial debit taken to enter the position.
The formula for calculating maximum profit is given below:

Max Profit = Strike Price of Short Call - Strike Price of Long Call - Net Premium
Paid Trading cost Paid

Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Limited Downside risk

The bull call spread strategy will result in a loss if the stock price declines at
expiration. Maximum loss cannot be more than the initial debit taken to enter
the spread position.
The formula for calculating maximum loss is given below:

Max Loss = Net Premium Paid + Trading cost Paid

Max Loss Occurs When Price of Underlying <= Strike Price of Long Call

Breakeven Point(s)

The underlier price at which break-even is achieved for the bull call spread
position can be calculated using the following formula.

Breakeven Point = Strike Price of Long Call + Net Premium Paid

Bull Call Spread Example

An options trader believes that XYZ stock trading at Rs 42 is going to rally

soon and enters a bull call spread by buying a JUL 40 call for Rs 3 and writing
a JUL 45 call for Re1. The net investment required to put on the spread is a
debit of Rs 2.
The stock price of XYZ begins to rise and closes at Rs 46 on expiration date.
Both options expire in-the-money with the JUL 40 call having an intrinsic
value of Rs 6 and the JUL 45 call having an intrinsic value of Re 1. This means
that the spread is now worth Rs 5 at expiration. Since the trader had a debit
of Rs 2, when he bought the spread, his net profit is Rs 3.
If the price of XYZ had declined to Rs 38 instead, both options expire
worthless. The trader will lose his entire investment of Rs 2, which is also his
maximum possible loss.

The bull put spread option trading strategy is employed when the options
trader thinks that the price of the underlying asset will go up moderately in
the near term. The bull put spread options strategy is also known as the bull
put credit spread as a credit is received upon entering the trade.

Bull Put Spread

Construction
Buy 1 OTM Put
Sell 1 ITM Put

Bull put spreads can be implemented by selling a higher striking in-themoney put option and buying a lower striking out-of-the-money put option on
the same underlying stock with the same expiration date.
Limited Upside Profit

If the stock price closes above the higher strike price on expiration date, both
options expire worthless and the bull put spread option strategy earns the
maximum profit which is equal to the credit taken in when entering the
position.

The formula for calculating maximum profit is given below:

Max Profit = Net Premium Received - Commissions Paid

Max Profit Achieved When Price of Underlying >= Strike Price of Short Put

Bull Put Spread

Bull Put Spread Payoff Diagram

Limited Downside Risk

If the stock price drops below the lower strike price on expiration date, then
the bull put spread strategy incurs a maximum loss equal to the difference

between the strike prices of the two puts minus the net credit received when
putting on the trade.
The formula for calculating maximum loss is given below:

Max Loss = Strike Price of Short Put - Strike Price of Long Put Net Premium
Received + Commissions Paid

Max Loss Occurs When Price of Underlying <= Strike Price of Long Put

Breakeven Point(s)

The underlier price at which break-even is achieved for the bull put spread
position can be calculated using the following formula.

Breakeven Point = Strike Price of Short Put - Net Premium Received

Bull Put Spread Example

An options trader believes that XYZ stock trading at $43 is going to rally
soon and enters a bull put spread by buying a JUL 40 put for $100 and
writing a JUL 45 put for $300. Thus, the trader receives a net credit of $200
when entering the spread position.
The stock price of XYZ begins to rise and closes at $46 on expiration date.
Both options expire worthless and the options trader keeps the entire credit
of $200 as profit, which is also the maximum profit possible.
If the price of XYZ had declined to $38 instead, both options expire in-themoney with the JUL 40 call having an intrinsic value of $200 and the JUL 45
call having an intrinsic value of $700. This means that the spread is now
worth $500 at expiration. Since the trader had received a credit of $200
when he entered the spread, his net loss comes to $300. This is also his
maximum possible loss.

2) The Collar Strategy

A collar is an options trading strategy that is constructed by holding shares
of the underlying stock (when there is a opportunity even a future can be
bought) while simultaneously buying protective puts and selling call options
against that holding. The puts and the calls are both out-of-the-money

options having the same expiration month and must be equal in number of
contracts.
Collar Strategy Construction
Buy Shares equal to 1 lot
Sell 1 OTM Call 1 lot
Buy 1 OTM Put 1 lot

Technically, the collar strategy is the equivalent of a out-of-the-money

covered call strategy with the purchase of an additional protective put.
The collar is a good strategy to use if the options trader is writing covered
calls to earn premiums but wish to protect himself from an unexpected sharp
drop in the price of the underlying security.

Collar Strategy Payoff Diagram

Limited Profit Potential

The formula for calculating maximum profit is given below:

Max Profit = Strike Price of Short Call - Purchase Price of Underlying + Net
Premium Received Trading cost Paid

Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Limited Risk

The formula for calculating maximum loss is given below:

Max Loss = Purchase Price of Underlying - Strike Price of Long Put - Net
Premium Received + Trading cost Paid

Max Loss Occurs When Price of Underlying <= Strike Price of Long Put

Breakeven Point(s)

The underlier price at which break-even is achieved for the collar strategy
position can be calculated using the following formula.

Breakeven Point = Purchase Price of Underlying + Net Premium Paid

Example

Suppose an options trader is holding 100 shares of the stock XYZ currently
trading at $48 in June. He decides to establish a collar by writing a JUL 50
covered call for $2 while simultaneously purchases a JUL 45 put for $1.
Since he pays $4800 for the 100 shares of XYZ, another $100 for the put but
receives $200 for selling the call option, his total investment is $4700.
On expiration date, the stock had rallied by 5 points to $53. Since the
striking price of $50 for the call option is lower than the trading price of the
stock, the call is assigned and the trader sells the shares for $5000, resulting
in a $300 profit ($5000 minus $4700 original investment).
However, what happens should the stock price had gone down 5 points to
$43 instead? Let's take a look.
At $43, the call writer would have had incurred a paper loss of $500 for
holding the 100 shares of XYZ but because of the JUL 45 protective put, he is
able to sell his shares for $4500 instead of $4300. Thus, his net loss is
limited to only $200 ($4500 minus $4700 original investment).
Had the stock price remain stable at $48 at expiration, he will still net a
paper gain of $100 since he only paid a total of $4700 to acquire $4800
worth of stock.
Summary

The beauty of using a collar strategy is that you know, right from the start,
the potential losses and gains on a trade. While your returns are likely to be
somewhat muted in an explosive bull market due to selling the call, on the
flip side, should the stock heads south, you'll have the comfort of knowing
you're protected.

Long Straddle

A long straddle options strategy is when an investor purchases both a call

and put option with the same strike price, underlying asset and expiration
date simultaneously. An investor will often use this strategy when he or she
believes the price of the underlying asset will move sigificantly, but is unsure
of which direction the move will take. This strategy allows the investor to
maintain unlimited gains, while the loss is limited to the cost of both options
contracts.

Iron Condor

An even more interesting strategy is the iron condor. In this strategy, the
investor simultaneously holds a long and short position in two different
strangle strategies.
Most investments are made with the expectation that the price will go up.
Some are made with the expectation that the price will move down.
Unfortunately, it is often the case that the price doesn't do a whole lot of
moving at all. Wouldn't it be nice if you could make money when the markets
didn't move? Well, you can. This is the beauty of options, and more
specifically of the strategy known as the iron condor.
How to Take Off
Iron condors sound complicated, and they do take some time to learn, but
they are a good way to make consistent profits. In fact, some very profitable
traders exclusively use iron condors. So what is an iron condor? There are
two ways of looking at it. The first is as a pair of strangles, one short and one
long, at outer strikes. The other way of looking at it is as two credit spreads:
a call credit spread above the market and a put credit spread below the
market. It is these two "wings" that give the iron condor its name. These can

be placed quite far from where the market is now, but the strict definition
involves consecutive strike prices.
See: Option Spreads Strategies
A credit spread is essentially an option-selling strategy. Selling options allows
investors to take advantage of the time premium and implied volatility that
are inherent in options. The credit spread is created by buying a far out-ofthe-money option and selling a nearer, more expensive option. This creates
the credit, with the hope that both options expire worthless, allowing you to
keep that credit. As long as the underlying does not cross over the strike
price of the closer option, you get to keep the full credit.

Figure 1

With the S&P 500 at 1270, one might buy the September 1340 call option
(black dot below point 4 on the above chart) for $2.20, and sell the
September 1325 call (black dot above point 3) for $4.20. This would produce
a credit of $2 in your account. This transaction does require a maintenance
margin. Your broker will only ask that you have cash or securities in your
account equal to the difference between the strikes minus the credit you
received. In our example, this would be $1,300 for each spread. If the market
closes in September below 1325, you keep the $200 credit for a 15% return.
To create the full iron condor, all you need to do is add the credit put spread
in a similar manner. Buy the September 1185 put (black dot below point 1)
for $5.50, and sell the September 1200 (black dot above point 2) for $6.50
for another $1 of credit. Here, the maintenance requirement is $1,400 with
the $100 credit (for each spread). Now you have an iron condor. If the market
stays between 1200 and 1325, you will keep your full credit, which is now
$300. The requirement will be the $2,700. Your potential return is 11.1% for
less than two months! Because this does not presently meet the Securities

And Exchange Commission's (SEC) strict definition of an iron condor, you will
be required to have the margin on both sides. If you use consecutive strikes,
you will only have to hold margin on one side, but this clearly lowers the
probability of success.
Tips for a Smooth Flight
There are several things to keep in mind when using this strategy. The first is
to stick with index options. They provide enough implied volatility to make a
nice profit, but they don't have the real volatility that can wipe out your
account very quickly.
But there is another thing you must watch out for: you must not ever take a
full loss on an iron condor. If you have been paying attention and are good at
math, you will have noticed that your potential loss is much higher than your
potential gain. This is because the probability that you are correct is very
high. In the above example, it is more than 80% on both sides (using delta as
a probability indicator that the market will not close beyond those strike
prices).
To avoid taking a full loss, if the market does what it normally does and
trades in a range, then you don't need to do anything and you can let the
whole position expire worthless. In this case, you get to keep your full credit.
However, if the market moves strongly in one direction or another and
approaches or breaks through one of your strikes, then you must exit that
side of the position.
Avoiding a Bumpy Landing
There are many ways to get out of one side of an iron condor. One is to
simply sell that particular credit spread and hold the other side. Another is to
get out of the whole iron condor. This will depend on how long you have left
until the expiration. You can also roll the losing side to a further out-of-themoney strike. There are many possibilities here, and the real art of the iron
condor lies in the risk management. If you can do well on this side, you have
a strategy that puts probability, option time premium selling and implied
volatility on your side.
Let's use another example. With the RUT at roughly 697, you could put on
the following iron condor:
Buy September RUT 770 call for $2.75
Sell September RUT 760 call for $4.05

Buy September RUT 620 put for $4.80

Sell September RUT 630 put for $5.90
The total credit is $2.40 with a maintenance requirement of $17.60. This is a
potential gain of more than 13% with an 85% probability of success (again
based on the delta).
The Bottom Line
The iron condor option strategy is one of the best ways for an option trader
to profit from an insignificant move in the price of an underlying asset. Many
traders believe that a large move upward or downward is needed for them to
make a profit, but as you've learned from the above strategy, handsome
profits are possible when the price of the asset does not really move far. The
structure of this strategy may seem confusing at first, which is why it is used
primarily by experienced traders, but don't let the complicated structure
intimidate you away from learning more about this powerful trading method.