Understanding the Basics of Option Hedging

As new traders flood the market, a return to the basics may help novices understand the fundamentals of options trading. To better assist them, we will be running posts diving into the finer details of options education. This week, we are looking at hedging -- a simple idea that often takes on a more advanced meaning when put into practice in the market.

If a trader is to make any sort of bet about the future of an investment, they may not necessarily want to put "all their eggs in one basket." A hedge, most simply, is an opposing position to a related asset. Hedging reduces the potential risk of adverse price movement, so if the security doesn't go the way you were hoping, you still have this opposing position to fall back on. At the end of the day, it limits the affects of both risk and reward.

A common example in daily life is insurance. For example, buying travel insurance costs some money, but it limits the risk of having to spend a great deal more money if something unexpected comes up. On Wall Street, it can be prudent to expect volatility, or, as we noted for insurance, the "unexpected." Hedging has investors transferring some of that potential risk in various ways, such as eyeing two sector competitors, both bullish and bearish options for the same stock, etc. 

For options traders, there are quite a few different strategies that can be used to hedge. Protective puts, for example, are used to hedge against losses on an existing stock position, while protective calls are often used by short sellers to limit the risk of potential upside.