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Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options, Second Edition by Andrew M. Chisholm

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9
Hedging with Options

CHAPTER OVERVIEW

Options can be combined together and with positions in underlying securities to construct many different trading strategies and risk management solutions. This chapter explores a basic option application, the protective put. This uses a put option to hedge against potential losses on a position in an underlying security.
A protective put can be combined with shorting a call, to construct a collar strategy. If the strikes of the put and the call are set at the right levels the premiums of the two options cancel out, and the strategy becomes a zero-cost collar. Alternatively, the protective put can be constructed using a nonstandard or ‘exotic’ option contract called a barrier option. This saves on premium, although the hedge ceases to operate in certain circumstances.

FUTURES HEDGE REVISITED

The case investigated throughout this chapter is that of an investor who owns a share currently trading at $100. The investor is concerned about the possibility of short-term falls in the value of the share due to general turbulence in the equity markets.
The investor could, of course, sell the share and deposit the proceeds in the money markets, or switch into another financial asset. However this will incur transaction costs, and may also trigger tax liabilities. In addition, the investor may have built up the shareholding over time and may prefer not to switch simply because of short-term problems. Furthermore, if the investor does make a premature ...

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