Put options are among the most common techniques to hedge risk in the options market. Because put options are a right to sell, you are still profitable on the upside once the premium cost is covered. Your risk is restricted to the difference between the buy price and the strike price plus the premium cost on the downside. Your losses must not exceed that amount under any circumstances. Let's look at several option hedging strategies and how to hedge with them. There are ten essential considerations to consider while implementing option hedging methods in India.
1. While utilizing options for hedging your position in the market, check that options are not in the money or at the money. This option can be costly and does not allow you to reach the break-even point. You can use option strike, which is out of money, so you do not have to risk more, and your risk factors decrease.
2. it would help if you avoided the Out of the money option. Initially, they may look cheap, and premiums are low, but the reality is that they close at a worthless price. So we recommend you option hedging strategies and try the put option strike above Out of Money to gain some profit.
3. While buying the put option for the hedging purpose, you need to check the price of that specific option, whether it is overpriced or underpriced. Every trading system or software has an inbuilt calculator; you can use this calculator to check the price. The ideal calculator is black and Scholes valuation. If you see that the options are overpriced in black and Scholes calculator, you should avoid buying them.
4. Traders may frequently find the cost of a put option expensive when calculating the break-even. As a result, they partially offer a more fabulous call to offset the option's cost. This has a disadvantage. While it lowers the cost of buying the put on a net basis, it also restricts your profits. Thus this call spread strategy should only be employed if you are fairly bullish.
5. Should you sell your put option if the stock drops dramatically? That is precisely what you should do. If your equity is a long-term investment, you should use a hedging strategy and must maintain changing your alternatives every month. Booking earnings allows you to lower your holding costs. For example, if you bought a stock for Rs.800 and made a profit of Rs.25 on a put option hedge, your stock's effective cost is now Rs.775. When you get the chance in any month, you must record profits on your put options.
6. Keep an eye on the put option's liquidity. We frequently discover that put options on specific mid-cap stocks are illiquid and that the basis risk is excessive. This is a well-known buyer's trap. If you don't acquire buyers at realistic prices, you can end up paying a lot of money when you want to exit your put option. A hedging strategy should ideally be implemented in stocks with significant liquidity.
7. Exit the put option position before the stock moves beyond the market-wide position limit of 85 percent. When the market reaches 90%, the stock enters a ban period, during which new futures and options bets are not permitted. While you will be able to terminate your existing position, the difficulty is that liquidity might quickly dry up when all of the demand is on one side of the transaction.
8. Keep track of the fees and taxes associated with transactions. The costs of buying a put option and then squaring it up include brokerage, GST, STT, stamp duty, turnover tax, and other fees. All of these factors will influence your break-even point. There's also the matter of taxes. Even though virtual losses on your cash market position are not tax-deductible, profits on your put option are taxable as company income when booked.
9. How do you hedge equities that aren't in your F&O portfolio? In such instances, perfect options hedging strategies are impossible. The concept of beta hedging can be applied to portfolio hedging. But, once again, this is an approximation and does not provide an exact hedge. This is especially true for small and mid-cap stocks that aren't listed on F&O.
10. When considering a long-term hedge, ensure that the current month's put option is immediately replaced with the next series's equivalent put option. When you leave a position open for an extended period without hedging it, the entire concept of portfolio protection is destroyed.
There is no specific route for option hedging strategies, but if you keep in mind these 10 rules, you might get success in the hedging process.