In this paper we will discuss about the correlation between options trading and hedging. In fact, hedging clearly shows the difference between a professional and amateur trader. Hedging is an important aspect of option trading. It refers to a practice that distinguishes the professional options trader from the amateur one.
Hedging has been enabling numerous professional options traders around the world to survive and as well as make huge profit over the last two decades. The amateur option traders should have a clear idea of hedging; otherwise they will not be able to reach their goals.
Hedging literally means “to hedge”, that is, it helps the traders to eliminate the risk factors, financial risk, market risk etc, from their options portfolio. Hedging involves in several calculated methods, which protect the trader’s options portfolio by offsetting the moves against the traders’ interests.
So it is not difficult to understand the need of hedging in options trading. The significance of hedging is not restricted only to the financial market. In our daily lives we can understand the utility of hedging. For example, insurances are made for hedging the risks caused by accident or unexpected financial expenses.
Therefore, hedging primarily means offsetting all kind of risks. However, in finance, hedging means entering any kind of transaction that will protect the traders’ portfolio from a sudden loss resulted from an unexpected price movement. This is also true for option trading.
A good way of hedging is to purchase that very stock that is going to increase as much as the trader’s option portfolio decreases. It is also one of the simplest ways of hedging as the trader is holding such stock, which has already earned profit. Moreover, the trader can buy another option contract whose value is also increasing. Therefore, if the value of the first stock decreases, an increase in the value of the second stock will nullify the loss.
Last Updated on : 23rd July 2013