Hedging with Options

Hedging enables the fund manager to transfer part of the risk with holding a position in the underlying instrument from one party to another. Options act like an insurance policy. There is a cost with hedging. It involves initial cash or opportunity costs involved such as potential profits and additional risk exposure in certain scenario.

Using Options to Protect an Equity Portfolio
Buying protective puts is the most obvious way to hedge a portfolio.  The investor selects the option with a specific expiry date and strike price, the level of risk assumed and the cost (premium paid) incurred is known.

Selling Covered Call is selling options against long position. This strategy does not offer limited downside risk compared to buying protective puts. Income (premium) generated from selling call options can mitigate a decline in the portfolio value, but the premium received may not provide much buffer when the stock/underlying asset's price falls sharply in the market. I have limited my gains when I previously sold call on SKX at $26, when the results came out, the price went up to $30 and as of 21st Jan 18, it is about $39. Selling Call can limit your upside and provide limited downside. If the stock price is neutral and does not move much, it can enhance your yield or premium can be considered as an income.

Zero-Cost Options
If an investor wants to hedge with very limited risk exposure, he can do so by simply purchasing an option. If he also wants to avoid putting up cash associated with such a strategy, he can achieve this by been cash neutral through simultaneously combining the purchase of the option with a sale of another option.

This is known as a zero-cost dollar, by buying protective put and writing an out of money covered call. The call option is sold with a strike price where the premium received is equal to the premium paid to buy the put. This zero dollar collar is used to protect existing long stock positions with little or no cost.