The investors are concerned about their investments in unfavorable and uncertain market conditions and to protect their investments and limit their losses, they choose options trading.
Option Buyers have to face limited risk and they also suffer limited losses due to the premium they paid. But at the same time, the Option Sellers have to suffer unlimited losses and make limited profits for the premium paid.
So it is mandatory for both of them to do Risk Management under certain conditions. A Stop Loss is a great way of hedging the risk involved with the trade as it limits the loss to the investor on his security position.
The traders can submit a limited order for selling at good Option Prices and Stop Loss helps them sell the same stocks even at a bad price. So, you need to consider the alternative strategies for investors to reduce the risk before making any final decision.
Every investor must know about Hedging in Risk Management before they can invest confidently into options.
As Option Buyers
Option Buying is a safe and secure way to limit the risk. Option Buyers pay a limited price and get higher rewards, Option Buyers can conveniently hedge the portfolio and secure their investment against declining prices. But if the market faces uncertainty, the Option prices may increase and the Option that had a trading price around 20 could be traded at 30 or 40.
Option Buyers can protect themselves against such Option price fluctuations by investing in long-term put options. It reduces the risk exposure and they can sell the stock at a fairly good price.
Buying is a simple and effective strategy that helps Option Buyers to protect themselves against price decline.
Let's see this with an example. If you are an investor who wants to reduce its loss of up to 10% on your stock, and your stock is currently traded at Rs.50. You may choose the put option with Rs.47 as a strike price offering each share at Rs.2. If your stock trading price is Rs.40 and you have a potential loss of 20% (Rs.10 loss is equal to 20% of Rs.50 price) when the put option expires, then you have the right to sell your 100 shares at Rs.47 as per the contract.
If the loss is up to 10% (Rs.5 loss is equal to 10% of Rs.50 price), then you can protect your stock against the 10% price decline. You can think that the price fall will not go beyond 10% until you start preparing yourself to suffer the potential loss.
As Option Sellers
The Option Sellers find opportunities from uncertain market situations because there is a rise in the Option prices. So, compared to normal returns, the Option Sellers may get up to 2 times or even 3 times higher returns in such situations.
The Options and Futures both have the same risk in an uncertain market. The traders sell the Options at a high price about the same time when the Higher Call or Lower Put is bought against the Higher Call or Lower put sold.
By doing this, the Option Sellers can convert the unlimited loss into a limited one. When the market is extremely unpredictable then Buying options are going to protect the Selling option positions.
During uncertain times, you can manage the risk with the help of the Option position.
Stop Loss Technique for Risk Management
Stop Loss is a very effective technique that traders can use to stop the potential losses in an unpredictable market. This technique can be used depending upon the type of stock, index, or commodity you have.
The Stop Loss technique is very easy to learn. You should know such factors that affect the trade. Many factors affect trade such as industry, global economy and financial factors, political and geographical factors, and last but not the least, the factors related to nature and weather.
This concept works in a better way when you consider the time's high-low average, so all the traders should always compare the previous trends of the stock, index, or commodity. Consider all the relevant factors before deciding the right amount to stop loss. By considering the pattern, you can accurately know which amount you can set.
When you are planning your Risk Management Strategy, your core preference should be the Stop Losses.
Hedging Technique for managing the risk
Hedging is a great strategy that is used to manage risk. It helps the investors to offset the losses of the investment by taking up an opposite position of a related asset. If you have heard that hedging can give you higher returns in any market condition whether it is a good or bad one, then you must know that when there is a possibility of higher returns, there is always a higher risk.
Hedging, therefore, is an easy and risk-free way to get returns. This benefits you by helping you reduce the risk but it also means you will have a reduction in profits. But you have to pay money as a premium for the protection it gives your investment.
Many other techniques help you in risk reduction like sizing your positions, checking when you’re trailing stops and optimizing your risk levels, minimizing the downside risk, and many others.
If you are a buyer or seller, you can benefit from the above basic strategies and reduce the potential losses. You must have the knowledge and idea about the concept and stock market before using any of the above tools. To reduce the risk, you can make a plan for your trade, and calculate the potential losses and returns accurately. The traders should learn when to enter the trader and when to exit before using any strategy or tools. They need to know about the Option Prices they have purchased the stock and what is the expiry date so they can plan and use the strategy in a better way.