I’ve hard of “hedging” when someone wants to “lock in” a position’s profit, without selling the stock. I was told this is for tax reasons because if you hold the stock over a year you get taxed lower.
But doesn’t that require additional capital? Do I use options?
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You can sell a call option on the stock and keep the underlying; basically you lock in the profit in exchange of giving up the upside
Have you ever heard the phrase “hedge your bet”? Hedging is the process of protecting yourself from loss. Let’s say you just gained a ton of money because the price of a stock you have just doubled over night. However you know that stock is volatile and the price might halve overnight and you would lose everything you gained. You could sell and keep the money but if you don’t want to do that there are a series of strategies you can do to reduce your risk.
One of those strategies is called a “put option”. Basically you pay someone a fee to give you the option to always sell your shares at a fixed price. Then, if the stock does halve tomorrow, you can instead sell your shares at that higher price at less of a loss.
Yes, you use options.
We’ll use an example that is most common – hedging currency risk. Let’s say that I make widgets in the US and sell them to a European customer. They want to pay in Euros, so we agree to sell them 1M widgets for 1M Euros in 6 months’ time. I spin up my factor and start making my widgets.
Right now, 1M Euros is worth 1.06M USD, but that could change six months from now. If I need to make at least 900k USD on the sale or I lose money, I might be very concerned that the exchange rate will change so much that I’ll lose money on the deal (since the 1M Euro price is agreed to already). That is currency risk.
To resolve this risk, I go out and buy an option to sell 1M Euros for 950k USD – this way, no matter what happens to the price in 6 months I am _guaranteed_ to get _at least_ 950K USD for my 1M Euros. If the exchange rate is worse for me I use my option, but if it is better I let my option expire and just use the current exchange rate.
This has _hedged_ my currency risk – I have locked in the _minium_ amount of revenue I can make on the deal at 950K USD.
Option-ese gets confusing, here’s my try for a five year old.
My stock is up, I want to keep it because I think it might go higher. But if it goes down I will regret not selling it now. So I buy a promise from someone. They promise to buy it at today’s price if I want, even if they can get it cheaper elsewhere. So they’re taking a risk, but I am paying them money to accept that risk. Now if it goes up I still have my stock, though what I paid the other person is lost. If my stock goes down I call in the promise and the other person buys it at today’s price and all I have lost is what I paid them for the promise.
This particular kind of option is a PUT, because I can PUT the stock on that person if I want. If I buy a promise that the person will sell to me at a certain price if I want them I am buying a CALL because I can CALL the stock to me. The person who will later have the option is BUYing the option. The person making the commitment to the purchase regardless of the price they could get elsewhere is SELLing the option. The price you pay for an option is called a PREMIUM.
There are many, colorfully-named ways to combine options to increase your risk and reward in playing the stock market. Mostly that’s gambling, but sometimes it’s part of a rational strategy. Actually, it’s almost always gambling since it’s a short-term thing.
Now you’re ready to do an Iron Strangle Condor or a Married Collard Bear Straddle!
This is easier to explain with sports betting I feel.
NZ and the UK are playing a rugby game. You make a bet with your mate 1:1 odds NZ wins – you gets $10 if NZ wins and they get $10 if the UK wins.
Then NZ beats SA in another game, and the UK loses to Australia. Suddenly, NZ winning looks much more likely.
You want to “lock in” your wins, so you talk to your other friend. They’re willing to make a bet 3:1 NZ wins – so you pay them $5 if NZ wins but they pay you $15 if the UK wins.
You’re now neutral on the outcome. Combining the two bets – If NZ wins you make $10 – $5 = $5, if the UK wins you make $15 – $10 = $5. You’ve “locked in” the profit or are “fully hedged”.
You can do the same to “lock in” a loss. Say that instead, NZ loses a few games. You think that it’s likely to get worse so, you bet your mate $5 to you if NZ loses, $15 to them if they win.
Now, combined with your first bet, you loose $5 no matter what happens, which is better than loosing $10 but ofc worse than just winning the original bet. Again you’re “hedged”.
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