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Options and Hedging

(managing downside risk)

Page Summary:
Many people look towards options, specifically Put options, to hedge against the risk of falling prices. But this advice is far from sound and usually, because timing is out, will result in losses. This article explains more.
The problem with using Options to hedge risk
Consider this statement -

If you want to hedge your downside risk - buy a Put option

At first glance that sounds correct because as the same commentators normally add - Put options rise in value when the underlying (in this case shares) fall.

So if you currently own 5,000 shares of BT and you think a stockmarket slump is around the corner buy 5 Puts (each option is worth 1,000 shares). If the market does slump your losses on the shares will be offset against profits made on the Puts.

However, this advice is generally wrong and if you follow it expect plenty of losses when trying to use options to hedge downside risk.

What is wrong with the statement
The two main problems with the statement are -
  • Problem 1 - Timing is not considered and it's absolutely critical when buying options, and
  • Problem 2 - Puts don't always increase when the underlying falls, they can fall in price because of option volatility
Problem 1 - Timing has to be considered
  • Assume that you buy 1,000 shares of ABC Industries at £5.00
  • However, you're nervous about the state of the overall market and want to hedge your downside risk
  • The month is January and you buy 1 March £4.50 put - this will limit your losses to £4.50 plus the cost of the Put, let's assume it cost £0.35

The market doesn't collapse. It trades sideways over the next few months and the Put expires worthless. The option expires worthless and the loss is £0.35 or £350 (1 option is on 1,000 shares).

Not such a good hedge, nevertheless you were happy to pay for the protection in case the market slumped.

But you are still nervous about the market and so in March you buy another Put option, this time the June £4.50 which also costs £0.35 (£350). Again the market trades sideways so the option again expires worthless. Another £350 in insurance costs down the drain.

You then buy the September £4.50 Put and that expires worthless. So at the end of 9 months you've paid out £1,050 in downside insurance and the shares are still trading where you bought them.

A hedge is supposed to save money but all the Put buying has offered is losses when trying to protect your shareholding. Remember that the shares haven't moved, either up or down.

Overall, buying the puts has been a financial disaster.

Point 1 Summary

Unless your timing is almost perfect, which for most of us it won't be, buying Puts as downside protection will probably only result in losses.

Yes, you might get lucky, your timing on any given trade might be good, or perhaps luck in on your side. But the key point is that if you do enough of these trades over a period of time it is odds-on that you'll only produce losses.

Problem 2 - Option volatility has to be considered

Some people describe option volatility as a fear factor, the higher the fear the more all options, both calls and puts, will rise.

And there's no denying that overall the markets are primarily ruled by both fear and greed. This often translates as people get more greedy when a market rises and more fearful as it falls.

My point is that when a market or share starts to slide people's perceptions move into the fear zone and hence it's the time when buying puts looks most attractive as they will offer protection from further losses.

This is why towards the end, never at the beginning, of any market slump, you'll often see a mad rush to buy Puts by inexperienced traders looking for downside protection. But these people normally don't know or understand the importance that volatility plays when pricing options.

So they'll buy the Puts when volatility is extremely high which means they will be fighting a battle on 2 fronts -

  1. Direction - the market has to continue heading lower, but chances are when they buy the Puts it will have already fallen considerably, and
  2. Volatility - If the downward momentum starts to slow down (high fear starts to evaporate from the market) the option price runs the risk of massively contracting even if the market continues to fall
In effect buying options when the market has already made a significant move and option volatility has risen considerably has little or no chance of making money.
Point 2 Summary
If you want to avoid losses it is most important to take account of option volatility and where it's currently trading and if it's risen significantly over the last few weeks or months. Ignore the maxim of - 'If you want to hedge your downside risk - buy a Put option'.
When options can be bought as a hedge
As ever, option volatility comes into play.

We know that if volatility is high it's tough to make money when buying options and holding them for a period of weeks or even worse months.

But if option volatility is historically low buying options can make sense.

This is why good stockmarket operators always keep an eye on the volatility level. They might not do anything in the options markets for several months or even a year or two. But if volatility goes low enough, hence options get super cheap, using them to trade direction (buying Puts or Calls) or using them to hedge downside risk (buying Puts) can often be a smart way to approach the markets.

How to hedge downside risk
In my opinion you can't properly use options to hedge downside risk because the only strategy worthwhile is to buy Puts. And as most, if not all, market participants struggle with timing, the trade will lose nothing but money if Puts are used continually.

The best way to hedge downside risk is to first realise what hedging actually means.

It doesn't mean limit your downside while still have unlimited upside potential. For example, if you buy a share at £5.00 it's impossible to lose if it goes lower but if it moves higher you'll get paid 100% of the profits.

Can you imagine if a financial product was developed that achieved this goal? If so, it would mean it's impossible to lose in the markets, only gain.

Protecting downside risk, as protecting your home from fire, will always cost money and often, with hindsight of course, the money will be wasted. For example, you probably paid between £150 - £500 to insure your house last year but did you make a claim? Probably not.

If I want to hedge my downside risk all I do is sell the shares, that is the perfect hedge. Again, a hedge means you fix a price, so if the market were to halve in value or double you'd neither lose nor gain.

Consider using CFDs to hedge
However some people don't want to sell their stock positions because it might trigger some hefty tax bills. In that case I'd advise shorting CFDs (Contracts for Difference) against the stock you own. For example -
  • You currently own 2,500 shares in BP
  • You're worried about the overall stockmarket and so sell short 2,500 BP using CFDs

At whatever price you sell the CFDs, that's your hedge price. If the shares were to rally 10% you'd make a 10% profit on the shares but lose 10% on the CFDs and vice versa. In effect whatever the shares did you'd neither gain nor lose.

Be wary of anyone who suggests that buying Puts options is a great way to hedge downside risk, unless they also mention the importance of both timing and volatility. If they don't you'll know that they have a limited grasp of options and how they work.

The best way for retail clients to hedge, and face it we don't have complex portfolios, is to just sell the shares and ride out any potential stockmarket storm in cash.

Remember, it's often the case that the successful stockmarket operator is better than many of his counterparties not because he picks better stocks, buying lower and selling higher than the rest. Rather, he loses less.

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