Option Investor
Educational Article

Options for Hedging Risk

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Options are best known as a vehicle for leveraged speculation. They are flexible, availing themselves of simple "buy and hold" strategies as well as complex spreads and hedges. They can be used as position insurance, portfolio insurance, or as the principal vehicle for a dizzying variety of speculative plays for retail and professional traders. They can be used to bet on the direction of a stock or index, or to sell premium or "time" to those who do. Options can be used to bet on where (and when) the price is going to go, or where it isn't. But options can also be used defensively to help manage risk in the broader sense, not just for professionals or active traders, but also for smaller retail investors. More recently, with the explosive growth of the options markets and the broadening range of securities for which options are now available, options can be used to hedge real-world risk with even a small portfolio.

Stock options, being the right to sell or buy an underlying stock at a fixed price for a fixed period of time, are now traded not just on stocks but also on indices and exchange-traded funds (ETFs) as well, not to mention options on futures and other exotica that are beyond the scope of this discussion. Some of these option markets are very deep and liquid, with manageable spreads and predictable executions, making them accessible even to small and part-time investors. Why is this so significant?

Investors usually think of investing as a way of generating gains- to buy something low and sell it high- or to sell high and buy low, as the case may be. Far less emphasis is placed on the ability to invest creatively and choose one's markets strategically, so as to hedge the unavoidable risk in one's existing investments. Such investments might include a house or other real estate, a car, or even a job. While investing for profit is an obvious, desirable no-brainer, structuring one's entire basket of investments defensively is a little less obvious, but can help investors and their families weather a far wider set of contingencies. Whether we like it or not, we are all market participants- when we buy food, when we gas our cars, when we choose our dwellings, when we go to work. Investing to help strengthen and stabilize us against unfavorable moves in those markets can help us not only maintain but build wealth regardless of what the future may hold.


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Why options? Why not simply buy and sell stocks and futures instead? Many investors and companies do just that. But options have a number of advantages that make them exceptional hedging vehicles even for small investors. Firstly, they offer pre-defined risk, in that by purchasing options, an investor's loss is limited to the amount invested. Unlike buying and selling stocks or futures on margin, option buyers can only lose what they put in. Yet they enjoy all the leverage that derivatives can offer. Further, long-term options, known as Long-Term Equity Anticipation Securities or LEAPS, allow investors to purchase contracts with years' worth of premium, thus reducing the need to actively track their positions and reducing the extent of premium decay.

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