Could anyone explain how do we buy or sell futures and hedge against it with call or put options?
Hedging futures with options is a very complex and tough job both theoretically and practically. It is because the return profile of futures is non-dynamic and varies only with the share price. But options, on the other hand, have a dynamic return profile and varies with share price, time, volatility and few more factors. So, you have to constantly adjust (change) your option positions to avoid inefficiently hedging your future positions, which will lead to enormous transaction costs.
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Thanks
I would like to know how the trade happens actually.
I mean how do I order. And if I have to exercise my options strike price how I’m gonna do that?
Hedging is generally an investment strategy. It consists of taking an offsetting a position in the same security. Hedging against investment risk means strategically using such instruments in the market to manage the risk of any adverse price movements. In other words, investors use hedge in one investment by making another.
Kirti … Yeah basically it is taking position against your own investment in case one trade goes wrong way. But I’m asking suppose I buy 10 future contract at 20 rs. Per contract . Then I want to hedge against it with options. Now with options one way to make profit is to make profit on the premium we are paying but as I know options gives us right to buy or sell at a price which is decided at the time contract was bought but maybe not be the same price as current. How do we perform that.
Hedging is the alternate term for “insurance” in the capital markets. That means you have to shell out extra amount to protect your futures portfolio. One way to hedge long futures position is by buying put options. Now here comes the complexity. You need to equate the net delta of your futures position with the net delta of your options position. Assuming you entered both the futures and option positions simultaneously, and you bought at-the-money put option, the strike price of which is the spot price of the futures, then, as the delta of a future contract is 1 and the delta of an ATM put option is 0.5, so you will need to buy 2 lots of ATM put option for every future contract you buy. However, this will only mitigate the delta risk at that point in time. As the spot price, volatility, time-to-maturity of option changes, you have to change the number of put options and that too also at different strike prices. As I said, its a very complicated process and such buying and selling of options for hedging purposes are used by institutional traders who can afford to spend that much amount in taxes and brokerage for each transaction because the position they are hedging may be worth in billions of dollars. So, they have to spend millions to save billions.
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