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Hedging; Protecting Portfolio with Options

ArticleID 116  
Writer Isaac Thuku
Category Personal Article

Hedging with options is especially attractive because they can give protection against loss. A hedger is an individual who is unwilling to risk a serious loss in his or her investing position and takes actions in order to avoid or lessen loss.

Using options to reduce risk

Suppose the investor currently holds the shares of the company X in his portfolio. The price of the share is 8 EURO. The investor is not sure the direction in which the share price will change. If the price grows, may be to 9 Euros, the investor might gain profits. However, if the price falls even by a small margin, the investor will suffer loss.

One way to avoid this downside risk is to sell the shares. The problem is that the investor may regret this action if the fall of the price of the share does not occur and investor has forgone the opportunity to earn a profit. An alternative approach is to retain the shares and buy a put option. This option will rise in value as the share price falls. If the share price increases the investor gains from his/ her underlying shareholding.

The hedging reduces the dispersion of possible outcomes to the investor. There is a floor below which losses cannot be increased, while on the upside the benefits form any increasing in the price of the share is reduced due to the option premium paid. But if the price of the share stands still 8 EURO, the investor may feel that the option premium he/ she paid to insure against an adverse movement at 10 percent of the share price was excessive. If the investor keeps buying this type of “insurance”, there can be substantial reduction in investor’s portfolio returns during the longer time (for example, a year).

Hedging; Protecting Portfolio with Options
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