Let’s assume an investor is holding 100 shares in a company called ABC. The investor believes that the value of ABC will increase substantially over the next few years, however, in the near term there is the concern that market volatility could cause short-term weakness in the share price of ABC.
To hedge the equity position, the investor could look at buying put options on company ABC. Each option contract will typically be the equivalent of 100 shares of the underlying asset. So, in this situation, one option contract would be enough to hedge 100 ABC shares.
The premium paid to open the contract would be the maximum loss the investor could incur from the option hedge – meaning the downside risk of buying the put option would have a predetermined limit.
A put option will rise in value if the underlying equity falls in value, so a loss to the investor’s shareholding would – to a varying extent – be covered by a gain in the option value. The extent of a gain would depend on how far the share falls in relation to the strike you chose for the option.
However, if the share price did not fall but rather gain, the investor would benefit from the gain in share price. This would be offset by the premium that was paid to open the option hedge which would now be left to expire as worthless.
Alternatively, let’s say a trader has a short derivative position on ABC shares, looking to benefit from a falling share price. The trader decides to protect against a rise in the share price by purchasing a call as a hedge. The trader would then pay a premium to buy the call option, which would be the maximum loss they could incur should the share price continue to fall.
A call option will rise in value if the underlying equity gains in value, so a loss in the short trade would be covered – to a varying extent – by a gain in option value. Again, the gain would depend on how far the share price falls in relation to the strike price you selected.