Hedging reduces margin requirements: Case of Option Spreads
In this article, we will be discussing what is hedging, how it can be used as a tool to minimize risk, and how it helps in reducing margin required for trading. By definition, hedging is a strategy used to offset losses in investments by taking a position opposite to the original position/trade in a related asset.
Writing/Selling an option contract not only requires a huge amount of money to trade but also attracts unlimited risk. For instance, you write an option of 17600 CE at a premium of ₹100. The margin required to write the option is approximately ₹1Lac. In this case, the maximum profit of the Option Writer is the premium to be paid for writing/selling it, i.e. ₹5000 (50*100).
However, if the market goes against the expected direction, the loss could be unlimited as the premium could increase to any number above ₹100. For writing an option, more risk means a higher margin will be required. In this context, hedging comes to the rescue. Hedging the position can help in reducing one sided unlimited risk in the trade; it also reduces the margin requirements in order to execute the trade.
A number of hedging options are available to a trader; Option spread strategies are one set of them. An Option Spread is nothing but a combination of positions taken with different sets of Strike for the same underlying asset and with the same Option Type. It has following advantages: a) Profits are limited in these positions but, so are the Losses b) Margin requirements for these positions are much lower as compared to Naked Option positions. Different types of Spread Strategies are as listed: Vertical Option Spread, Bullish Vertical Spread using Call Options, Bullish Vertical Spread using Put Options, Bearish Vertical Spread using Call Options, Bearish Vertical Spread using Put Options, and Horizontal Spread.
A vertical Option Spread is created with different strike prices of the underlying asset. A combination of either the Call Options (CE), or the Put Options (PE) may be used. These can be classified as Bullish Vertical Option Spread or Bearish Vertical Spread.
As an example, A Vertical Spread (Bearish or Neutral View) using Call Options has the following attributes:
– It is used when the expected market outlook is bearish/neutral.
– It is deployed with a trader wishes to reduce the margin requirements for Writing/Selling a naked call option
– To create such a spread, a trader will be required to sell a Call Position of lower Strike Price and buy a Call position of higher Strike Price.
Let us say, Nifty is currently at 17325 and the expected market outlook is bullish. In this case, a trader can sell a position of 17600 CE and buy a position of 17650 CE. The margin required to write/sell 1 Lot of 17600 CE is approximately ₹1 Lac and to buy 1 Lot of 17650 CE a trader will need to pay full premium. However, if a trader hedges his buy position with the sell position, the required margin is approximately ₹20,000 (almost 80% less than the position without hedging).
In conclusion, risk is minimized. Maximum loss will hardly be ₹3000 but the downside is that potential profit outcome is also reduced. Now that may be troubling to some traders: The notion of reduced profits. But we have a solution for this too. So, in order to overcome this situation, instead of buying 17650 CE, one can buy 17800 CE, 17900 CE; in other words, buy even more higher strike priced call options in order to maximize profits with low margins.
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