Be it emergence of International Tensions or Macro Economic uncertainties. Equity market comes across such risky times every few months. During such times risk increases. Risk that we are talking about here is the risk of loss that is difficult to control.
Uncertain times bring with them a lot of unpredictable moves and above normal prices of options. Let us look at managing three such risks that come up due to rising uncertainty and how to manage them using Options.
Directional Future Trades: Futures trading is fairly simple where risk management can be done easily by maintaining a stop loss on Buy or Sell Future trade. However, during uncertain times, such stop losses may get triggered and we may not even get a chance to execute them.
Imagine we bought a future with a stop loss in mind and post the closing of the market there was an international event that created turmoil in international markets. In such cases the Stop Loss mechanism would not work because the market may open at a price much below our stop loss price.
To manage risk of loss in such times, we can convert our future into a protected future position. Here we simply buy a Put option along with buying futures. This can help us in getting saved in case of market opening with a big drop.
Hedging, a must know activity for risk management
This kind of protected futures position can give us courage to go ahead and do bargain hunting with limited risk and with confidence.
Option Buyers: We all know that option buying is one of the safest trades with risk always limited to price we pay and reward much higher than that. However, when uncertainty hits the market Option prices do tend to go up. This could mean, the same Option that was trading at 10 could be trading at 20 or even 30.
This rise in Option prices becomes a risk because if the tension that has caused this price rise eases, the prices may come down back to 10. The drop may come without any movement in underlying or passage of time.
To save us from these price fluctuations in Option prices due to uncertainty, we Sell Higher Call/ Lower Put against Call/ Put bought. This will limit our profit to the Strike of the Option we sold, but it will save us from fluctuations with the help of the Sold option. Trick here is to choose the Higher Call/ Lower Put strike to Sell that is closest to the target price of our trade.
Option Sellers: Option Sellers can get easily attracted to such market situations with uncertainty due to the rise in Option prices. This is because the Sellers would get 2X or even 3X for the same Options sold in normal times.
Risk here is the same as Futures of a big unfavourable move. To manage this risk, we can still sell those high price Options but at the same time we should buy even higher Call / even lower Put against the Higher Call/ Lower Put that one has sold.
This will turn our unlimited loss trade of Option sell into a limited loss trade. This is because in case of a big unfavourable move, our Buy option will protect our Sell Option position.
These are the 3 different trades on Futures and Options where risk can be managed by addition of an Option position during uncertain times.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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