Hedging Strategies with Options for Beginners: Protecting Stock Holdings with Protective Puts and Collars

In the ever-changing world of investing, protecting your portfolio from downside risks is just as important as generating returns. Options provide a versatile tool for hedging existing Stock holdings, allowing investors to mitigate potential losses while still benefiting from upside potential. This article explores how options can be used for hedging, focusing on two simple strategies: protective puts and collars. By understanding these strategies, beginners can learn to safeguard their investments in the Indian market.

Protective Put Strategy

The protective put Strategy is a straightforward hedging technique that involves buying a put option to protect an existing long stock position. This strategy is particularly useful when you anticipate potential market volatility or downside risk but still want to maintain exposure to the upside potential of the stock.

How it Works

To implement a protective put strategy, follow these steps:

1. Identify the stock in your portfolio that you want to hedge.
2. Purchase a put option on the same stock with a strike price at or below the current market price.
3. The put option will give you the right, but not the obligation, to sell the stock at the predetermined strike price.

Example: Hedging Reliance Industries Limited (RIL)

Suppose you hold 100 shares of RIL, currently trading at ₹2,500 per share. To hedge this position, you can purchase a put option on RIL with a strike price of ₹2,450 and an expiration date of one month from now. Let's assume the put option costs ₹50 per share, or ₹5,000 for 100 shares (Current lot size of 250. Consider this as example only).

If RIL's stock price falls below ₹2,450 before the expiration date, you can exercise the put option and sell your shares at ₹2,450, limiting your downside risk. If the stock price rises, you can let the put option expire worthless and benefit from the upside potential.

The maximum potential loss in this scenario is limited to the cost of the put option premium (₹5,000) plus the difference between the current market price and the strike price, if the stock falls below the strike price.

Collar Strategy

The collar strategy combines the protective put with a covered call option, providing downside protection while also generating additional income from the premiums received from selling the call option. However, this strategy caps the upside potential of the stock position.

How it Works

To implement a collar strategy, follow these steps:

1. Identify the stock in your portfolio that you want to hedge.
2. Purchase a put option on the same stock with a strike price at or below the current market price.
3. Sell (write) a call option on the same stock with a higher strike price and the same expiration date as the put option.

Example: Hedging Infosys Limited (INFY)

Suppose you hold 100 shares of INFY, currently trading at ₹1,500 per share. To hedge this position using a collar strategy, you can:

• Purchase a put option on INFY with a strike price of ₹1,450 and an expiration date of one month from now. Let's assume the put option costs ₹30 per share, or ₹3,000 for 100 shares.
• Sell (write) a call option on INFY with a strike price of ₹1,550 and the same expiration date as the put option. Let's assume the call option premium is ₹20 per share, or ₹2,000 for 100 shares.

In this scenario, the maximum potential loss is limited to the cost of the put option premium (₹3,000) minus the premium received from selling the call option (₹2,000), plus the difference between the current market price and the put strike price if the stock falls below ₹1,450.

However, the upside potential is capped at the call strike price of ₹1,550, as the shares may be called away (obligated to be sold) if the stock price rises above that level.

Frequently Asked Questions

1. What is the purpose of hedging with options?

   • Hedging with options allows investors to protect their existing stock holdings from downside risk while still maintaining exposure to the upside potential of the stock.

2. How does the protective put strategy work?

   • The protective put strategy involves buying a put option on the same stock that you hold. If the stock price falls below the strike price, you can exercise the put option and sell your shares at the predetermined strike price, limiting your downside risk.

3. What is the maximum potential loss in a protective put strategy?

   • The maximum potential loss is limited to the cost of the put option premium plus the difference between the current market price and the strike price, if the stock falls below the strike price.

4. How does the collar strategy differ from the protective put strategy?

   • The collar strategy combines a protective put with a covered call option. It provides downside protection but also caps the upside potential of the stock position by selling (writing) a call option with a higher strike price.

5. What are the advantages and disadvantages of the collar strategy?

   • The collar strategy provides downside protection and generates additional income from the premiums received from selling the call option. However, it caps the upside potential of the stock position, as the shares may be called away (obligated to be sold) if the stock price rises above the call strike price.

Conclusion

Hedging with options can be a powerful tool for beginners in the Indian market to protect their existing stock holdings from downside risk. Strategies like protective puts and collars offer simple yet effective ways to mitigate potential losses while maintaining exposure to upside potential. By understanding these strategies and their mechanics, beginners can learn to manage risk more effectively, safeguarding their investments in a volatile market environment. Remember, continuous learning, practice, and a comprehensive understanding of risk management techniques are essential for successful options trading and hedging.