Hedging in option trading involves opening a position or multiple positions that will offset risk to an existing trade. It is an investment strategy that protects a portfolio from adverse price movements. Hedging strategies are used by investors to reduce their exposure to risk in the event that an asset in their portfolio is subject to a sudden price decline. Hedging can involve buying one instrument and subsequently selling the other to offset the risk.
In option trading, put options are a classic hedging instrument. They give investors the right to sell an asset at a specified price within a predetermined time frame. Investors can buy put options as a form of downside protection for their long positions. The pricing of options is determined by their downside risk, which is the likelihood that the stock or index that they are hedging will lose value if there is a change in market conditions.
Hedging with options can limit risk to a known amount, but it cannot entirely remove all risk. Hedging can involve a variety of strategies, but it is most commonly done with options, futures, and other derivatives. Basic trading strategies include taking a position in the option and the underlying stock, spreading, and combination.
It is important to understand how options work before starting to hedge, as they are complex instruments. Options tend to be cheaper the further they are from expiration and the further away they are from the money. Hedging with options can be done in a risk-free environment with a demo account.
