Although future and options techniques may not remove all market risk, they can aid in protecting a portfolio’s assets.
Options and futures are two financial tools that investors may use to earn income or protect existing holdings. An investor may hedge an investment at a certain price and on a specific date using an option and a future. Let’s learn more about them today.
What is Hedging?
As its name suggests, a hedge is an artificial row of bushes used as a barrier for confinement, protection, or defence. It is a strategy used by the investing sector to decrease the risk of price volatility among financial assets.
Risks involving the decline of the value of the assets may be reduced or eliminated using hedging. If the asset depreciates, the loss is limited to a certain amount. A hedge is the insurance policy of an investor since it protects earnings and portfolios while minimizing losses.
Popular Hedge Contracts(future and options)
A contractual obligation to swap an underlying asset at a future date and price is known as a futures contract. It is possible to customize contracts for futures based on standard contractual provisions. They are traded over the counter and generate immense profits at the end of the agreement.
Hedging with futures contracts is a common way to hedge. However, their liquidity and margining possibilities make them an attractive option for trading speculation.
Determinants of a Futures Contract
- Underlying Asset – Stock, stock index, commodity, or currency
- Expiration Date – Usually quoted in months
- Specified Price
- Contract Size (mainly standardized; example: the contracts for oil are standardized at 1000 barrels/contract)
- Type of Delivery (physical or cash-settled)
- Tick Size (minimum increments that the price will move by)
- Initial & Maintenance Margin
Suppose a producer of oil wants to produce 1 million barrels per year and be export-ready in 12 months. Let’s assume that the current oil price per barrel is $75. The oil is produced and sold at the prevailing market price.
The current market price may change due to the volatility of oil prices. If the oil producer believes that oil prices will rise in one year, he may decide against locking in a price at this time. If he feels $75 to be an acceptable price, he may sign into a futures contract to lock in a set selling price.
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Option Contracts confers the right, but not the duty, to purchase or sell an underlying asset at a determined price by a given date. The counterpart of each contract must be provided by the party exercising its option. There are two primary options:
- to acquire an underlying asset at a specified future date and price
- future obligation to sell the underlying asset at a stipulated price
Option trading serves both risk management and speculating purposes. Investors have the right but not the duty to execute options and use them to speculate while minimizing losses. It is also feasible to use unique strategies by mixing calls and puts in various ways.
Determinants of an Option Contract
- Underlying asset (commodity like gold or equity-like share)
- Expiration Date
- Strike Price
- Contract Size (example: most stock options are in contract sizes of 100 shares/contract)
- Type of Delivery (physical or cash-settled)
- Option Premium
- Type of Options (American vs. European)
Two Main Types Of Options Available In The Derivatives Market
For Instance: The option holder can acquire 1,000 barrels of oil at $50 per barrel in one year. Suppose the spot price of oil reaches $55 per barrel after one year.
The call option holder will exercise it since the only alternative is to buy it on the spot market for $55 per barrel, but the call option contract permits them to purchase it for $50 per barrel. The option holder would not exercise the call option if the spot market price were less than $50 one year from today.
For Instance: Consider that the put option entitles the holder to sell 600 barrels of oil at $1,500 per barrel within six months. If the barrels price were more than $1,500, you would not exercise the option since you could sell your oil for more than $1,500 on the current market.
You would pick this option if the price of oil per barrel were less than $1500, as you would be selling at a more excellent price, in this example, $1500 per barrel. Top brokers in India could assess you in hedging through this.
The Final Word
Frequently, investors use options and futures to hedge their holdings. Although hedging is a risk-reduction technique, poorly managed hedging may backfire, while well-managed hedging may be the most vigorous defense against an oncoming stock market disaster. Therefore, hedging requires both risk management and money management.