11.35What is option hedging?
1What is it?
Using options to limit losses on existing positions, e.g. buying a put on a stock you own, or buying a protective option against a short option.
2Why does it exist?
Options let you cap your maximum loss for the cost of a premium.
3Stock market example
Option sellers often buy a further-OTM option to turn unlimited risk into limited risk (that is what spreads do). SEBI also reduces margin for hedged positions.
4Quick revision
- Options cap downside.
- Cost = premium.
- Spreads turn unlimited risk into limited risk.
5Knowledge check
Q1. How to hedge a stock you own?Show answer
Buy a put.
Q2. How to cap a short call’s risk?Show answer
Buy a higher-strike call (call spread).
Q3. Cost of hedging?Show answer
The premium paid.