Risk free Hedging Portfolio
Hedging simply refers to minimizing risks of losses in case the value of stocks that an investor has purchased reduces below a certain predetermined value. There are various methods of hedging that investors can exploit to reduce the risk of uncertainty (Arnold, 2008). One the methods that can be used using stocks and options to create risk free hedge portfolio is the call option. This method gives the owner of the option the right to buy stock at a predetermined price within a specified time period. The predetermined price is known as the strike price. For instance, an investor buys a call option for $15 and the call option specifies that he can buy 100 stocks of company XYZ stock at a strike price of $120 within the next two months. In the event that the price of XYZ stock falls below $120, the investor does not exercise his buying option and losses the $15. However, if the price rises above $120, he exercises his option and buys the stock at $120 and sells it at the prevailing market price thereby making a profit.
Another method that can be used using stocks and options to create a risk free hedge portfolio is the put option. It gives the owner the right to sell stocks at a strike price during a given period of time. For example, an investor may buy a put option to sell 200 shares of stock of XYZ at $150 during the next two months. In the event that the share price rises above $150 in that period, the investor will not exercise the option but just sell the stock at the higher price. However, if the prices fall below $150, he exercises the option and sells at $150.
These two examples show how options can be used with stocks to cushion the investor from the risk of uncertainty in the stock market. They reduce the investors risk exposure in the event that the market does not behave in the manner in which the investor had anticipated (Korn, & Korn, 2001).
Importance of option pricing
Effective use of options in risk management does not only involve the use of the right options but also buying and selling at the right option price. Option price determines the return a trader will obtain when he/she exercises the option. If an option is highly priced, the trader may not earn significant returns even if the price of underlying stock on which the option is placed moves in a favourable direction. A trader therefore needs to know the concept of pricing. It also helps in determining whether the trader should exercise the option or not.
The decision on whether to exercise an option or not depends on the market value of the underlying stock (stock on which the option is placed) and the strike price (the fixed price at which the underlying stock will be purchased or sold) (Cohen, 2003). Option pricing can be applied as follows:
- Call option:
If the market value of the underlying stock is more than the strike price, the trader will earn a return equal to the difference of the two values if the option is exercised. In this case, the trader should exercise the option. On the other hand, if the strike price is more than the value or market price of the underlying stock, the trader will lose if the option is exercised. The option should therefore not be exercised.
- Put option
If the value of the underlying stock is less than the strike price, the buyer of the option should exercise the option. However, if the market value of the underlying stock is more than the strike price, the buyer of the option should not exercise the option (Johnson, 2007).
References
Arnold, R. A. (2008). Economics (5th ed.). Cincinnati, Ohio: South-Western College Pub..
Cohen, J. M. (2003). Put options: how to use this powerful financial tool for profit and protection. New York: McGraw-Hill.
Johnson, B. (2007). Options trading 101: from theory to application. Garden City [N.Y.: Morgan James Pub..
Korn, R., & Korn, E. (2001). Option pricing and portfolio optimization: modern methods of financial mathematics. Providence, R.I.: American Mathematical Society.
