Using Options to Hedge Your Portfolio

08/14/2015 8:00 am EST

Focus: OPTIONS

One way for traders to protect themselves against short-term adverse moves is to purchase or sell options to protect their portfolios, so David Becker, at FXEmpire.com, outlines both the upside and the downside of purchasing options as protection.

There are plenty of times that you may own a currency pair, commodity, or equity index that you want to hold, but you are leery about the current market environment.  One way to protect yourself against short-term adverse move is to purchase or sell options to protect your portfolio.

An option is the right but not the obligation to purchase or sell a financial asset on or before a specific date.  The price that you agree to sell or buy your security is referred to as the strike price. This price allows the buyer of the option to sell the underlying security to the seller of the option on or before the expiration date. If you decide to exercise your option before the expiration date, you will need to post capital to purchase the currency, commodity, or shares.  The amount of money you pay for the right to own an option is called the option premium.

So the benefit of purchasing an option is that it allows you to purchase protection at a specific price and the most you can lose on your protection is the premium you pay for it.  For example, if you own gold and believe the price will move higher, but you are concerned about an event that could temporarily push it lower, you could purchase a put option on gold prices, which would provide you the right to sell gold and the most you will lose is your premium.

So, what is the downside toward purchasing options as protection?  The answer is that options are priced based on the probability that a market will move to a specific level by a certain date.

If the price gets to your target after expiration your insurance is actually worthless. Additionally, the longer the tenor of the option, the more expensive it is with all other components remaining equal. So if you purchase a put option that is the right to sell a stock or currency pair at the current price, an option that expires in 90 days will be more expensive than an option that expires in 30 days.

The price of an option is based on many factors, including the current price relative to your strike price, the tenor of the options, as well as the probability that the market believes the underlying price will make it to the strike price.  This is called the implied volatility, and when market participants are fearful, implied volatility rises.

The key is to hedge your exposure when the market environment is complacent. When you feel comfortable, it is likely the time to hedge. Once you become fearful along with the rest of the market, option prices will move higher.

By David Becker, Contributor, FXEmpire.com

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