Use Options to Hedge Investment Risk

The stock market is off to a good start in 2012 but is it time to use options to hedge investment risk? The S&P 500 has climbed a hundred points since the beginning of the year. A European debt bailout becomes a reality and US economic figures slowly improve. The stock market is discounting this information and driving stocks steadily higher. However, there are times when the market gets ahead of itself and drives stock prices higher than earnings and other fundamentals will support. With this possibility in mind smart investors often use options to hedge investment risk. In an ascending market options traders often use technical analysis tools to anticipate changes in market sentiment. They will purchase puts on rapidly rising stocks in their portfolio. Using this long options strategy an investor protects his stock gains against an unexpected correction. However, buying puts on rising stocks in not just the province of long term investors who use options to hedge investment risk. Options traders may simply buy puts on a risking stock because they believe it will soon fall in price. Their investment is the price of the stock option and their risk is limited to the same.

In a rising market investors can also use options to hedge investment risk. In this case the investor buys calls because he expects the stock to keep going up in price. As with buying puts the risk is limited to the price of the options contact. If the stock price falls the investor will incur a small loss in a well chosen call contract. If the stock rises significantly in price the investor is able to execute the call contract and buy the stock at the contract or strike price. He can do this no matter how high the spot price or current stock price rises. This can be an excellent means of buying stock when the investor is not certain if a stock will keep going up or not. The difference between strike prices and options prices in options trading are where profits lie. With the use of fundamental and technical analysis an investor or options trader can profit from both rise and fall of a stock price.

An options trader or an investor need no limit his trading and only use options to hedge investment risk. Options traders often use a variety of put and call combinations in order to profit from anticipate movement of stocks while avoiding undue risk. Traders can also guarantee profits no matter which direction a stock moves in price. For example, a long straddle options strategy involves buying both a put and a call on a stock with the same expiration date. The cost is the price of the put and the call. The trader can profit if the stock goes up or goes down. Only if the stock does not move in price does he lose the price of the premiums paid. However, the same trader can also sell calls or puts on the same stock with the same expiration date. The trader receives the price of the options that he sells which can offset the price of the options that he buys. By careful and up to the minute analysis of stock options it is possible to enter into trades that have no risk of loss but still have a likelihood of profit.

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