Options Theory: Hedging Basic Series Part 2 – Why do Traders Hedge?
October 29, 2017
Last update: August 2021
Hedging Basic Series [Free Articles]
- Part 1: What is Hedging?
- Part 2: Why do Traders Hedge?
- Part 3: When to Place Your Hedge
- Part 4: How to Hedge a Naked Put
In part one of our new series on hedging, we defined precisely what the concept means. Today we’re turning to the why. Namely, why do trader’s hedge? After all, they could simply exit their trade to limit the loss, so why fiddle with hedging at all?
I can think of two situations where hedging a trade is advantageous. The first case involves a profitable trade and the second involves a losing one.
Compromise for More Cash
The following sentence explains the gist of why you would hedge a winning trade. Memorize it so that next time you’re in the same situation, you’ll know hedging is the answer.
The following sentence explains the gist of why you would hedge a winning trade. Memorize it so that next time you’re in the same situation, you’ll know hedging is the answer.
I have a profitable position and am looking to reduce risk, but I don’t want to completely exit the trade.
So, I hedge. Think of it as a compromise to staying all-in or getting all-out. Let’s look at an example. Suppose I purchased a November 85 call on ABC stock for $3. Over the next two days, the stock rallies lifting the value of the call option to $4.50. Instead of exiting to lock-in the $1.50 gain, I could hedge the position to reduce my overall risk thereby making it easier to let my winner ride. Think of it this way – the hedge reduces the risk so if the stock drops back I don’t give back my profits as fast, but at the same time, if the stock continues to rise I can still rack up additional gains.
That, friends, is a win-win.
In this instance, the hedge (aka trade adjustment) I would consider is shorting an out-of-the-money call option to roll into a bull call spread. Suppose I sold the November 90 call for $1.50. Let’s look at the position before and after the hedge.
Before:
Long November 85 call with $3.00 of risk
Hedge Added:
Short November 90 call for $1.50
After:
Long November 85/90 bull call for $1.50 of risk
If the stock keeps rising, I will continue to rake in additional gains, but if it drops back I now only have $1.50 of risk instead of $3. What traders find challenging is knowing which options to use when hedging. Furthermore, how you hedge a profitable call option will be different than how you hedge a bull call spread. In a future article, we’ll walk through numerous examples to help get you started.
I Need a Band-Aid
The second and arguably more common situation where traders look to hedge is when they have a losing position. Like the winning trade scenario, here are a few sentences to memorize that encapsulates why a trader would hedge a losing position.
I have a losing position that I’m unwilling to exit. I want to give it a chance to work, but need to reduce the risk in the meantime.
The most common scenario is when you have a positive theta trade that you’re desirous to remain in so you can milk more profits from time decay. You think you can recover the loss over time, but you want to make it easier to stay the course.
That is the typical situation where hedging is more attractive than exiting. Suppose I hold a November 100/105 bear call spread in XYZ, entered initially for a 75 cent credit. Because I firmly believe XYZ will fall over time, I want to stay in the position to both milk time decay and provide the stock a chance to work finally.
In this instance, the hedge I would consider is adding an out-of-the-money bull put spread which morphs the trade into an iron condor. Maybe I add a November 95/90 bull put for 75 cents. If XYZ keeps rising the profit from the bull put should offset, at least in part, the loss incurred from the bear call.
Before:
Short November 100/105 bear call spread with $4.25 of risk
Hedge Added:
Short November 90/95 bull put for 75 cents credit.
After:
Short November 90/95/100/105 iron condor with $3.50 of risk
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Good cut and dry approach to hedging
Thanks for the lesson on the “why” of hedging!
Nice article. Looking for more.