How can you use options and futures markets to hedge risk in TA projects?

Its important to realize that there are ever only 2 types of traders in the markets, speculators and the hedgers. If you have just bought a call/put without any hedge, you're gambling (gaming*). Options are primarily used to hedge an underlying asset to protect against the eventual corrections. Futures gave us a way to long/short at market prices which become the default strike price, but in options you can have a random strike price that is technically impossible for the price to reach, but you can definitely write an option against that security and collect premiums on the same. The hedging methodologies are many, but the basics of options is that they are used to generate alpha even when the market is against your net spot positions.

Options are complex derivatives instruments which are used for different purposes. I have been an option seller for the past three years and the option pricing is affected by the volatility of the market. Options are of two types- 1. Call Options- which are used while bullish if bought or if sold then bearish. It is also used if want to take delivery of that security at a future date. 2. Put options are used for bearish if bought or sold for bullish. It is also used to give delivery of that security at a future date. In general, Options (Call or Put)+ Strike Price ( at which you have a view that it goes beyond that price) + Expiry( the date at which the options premium sets zero with settlement)

Financial derivatives that provide its holder with the right but not an obligation to purchase or sell an underlying asset at a fixed price before expiration date are options. In the context of Technical Analysis (TA) projects: Call Option: Grants the right to purchase the underlying asset. Put Option: Gives the right to dispose of an underlying asset.

How do you hedge futures and options? With Futures and Options trading, you can use long Long(Buy) and short (Sell) hedges to reduce your upside and downside risks. When an investor takes a short position on a Futures contract and buys a Put Option, it is termed a short hedge

In many 'infant stage' markets like Sri Lanka no hedging instruments to LIMIT RISK of losing money due to holding 'naked' positions of equities are immense. Therefore it is high time we introduce such instruments like options and futures. Some time ago people were talking about introducing short selling. It is dangerous to introduce short selling without allowing options!!! Moreover we must first have strong 'investment banks' with adequate portfolioes of stocks to freely lend to short sellers!!!

Futures in simple language is that you bought a specific product let's say an iPhone at 100$ which is worth 1000$ and told the seller that you will pay the full by next month. In this case, the 100$ is the margin you have and the 1000$ the contract size while the end of the month is the expiry date on which you will settle the contract. Now you understand the futures, so let's see how this instrument be used, it can be as for hedging, speculating and arbitrage. You believe that the price of the iPhone which is currently 1000$ will go up by next month but you don't have the funds to accumulate the iPhone then make a contract with the seller that you will pay 100$ for each iPhone you buy and will pay fully by end of next month.

Futures contracts represent agreements between parties who agree to sell or buy an asset at a future date and price. Futures contracts are standardized and take place on organized exchanges. Key points for TA projects include: Standardized Contracts: Futures contracts have standardized terms, such as contract size and expiration date. Leverage: Often futures trading involves the use of leverage, which allows traders to manage a larger position with less capital.

Futures, like a farmer securing a wheat harvest, involve standardized contracts. Imagining a farmer worried about potential price drops, they make a deal with a bread maker. This agreement ensures that in three months, the farmer will sell a ton of wheat at the current price, regardless of market changes. So, in simple terms, a future is like a promise to buy or sell something at a set price in the future, locking in the current price to avoid uncertainty. It's a way for people to manage the risk of changing prices for things like crops, currencies, or other goods.

The most cost-effective way to hedge is by using vertical spreads with options. For a bullish stance, opt for a bull call spread, and for a bearish view, choose a bear put spread. Keep an eye on the position, adjusting as necessary, and be mindful of potential gains and losses. Regularly review and learn from the process to refine your strategy. Integrating credit spreads into your hedging strategy provides flexibility and potential income, but it's crucial to thoroughly understand the risks and complexities involved in options trading. Regularly review and adapt your approach as needed.

Options can be powerful tools for risk management in various financial strategies. Married put and covered call are two strategies to hedge portfolio risk. Covered calls are suitable for investors who are willing to limit their potential upside in exchange for income and some downside protection. Married puts are used to maintain a long position in a stock but seek protection against potential downside risks. For bullsih and bearish view, vertial spread can be used as they are risk hedged strategies. These are designed to control risk and provide a more cost-effective alternative to simply buying a call or put option outright. Sell an option and buy another option with the same expiration date but different strike prices.

Use of a call or a put option to hedge is really for professionals. Short sellers buy a call options. Put buyers are interested in protecting price gains already made, but don’t want to sell the security for whatever reason. In my practice, I see a noticeable use of put options after a market has gone up substantially like it had in Q3 of 2023. The recommended approach is to buy puts that are “at the money” i.e. the strike price is near the current price, and have a long expiration (90 days). These are more expensive but they don’t quickly lose value. If the price of the security drops the price of the put rises. If the price continues upward, you can sell the put without losing too much of its value because it is long dated.

Options can be very useful in hedging against risky bets, it will work like insurance against your investments and trades. If any person wants to hedge his portfolio can have put options which will insure at uncertain times. I usually hedge my futures bets which are highly leveraged and can become very volatile and hamper your psychology. Some investors use a covered call strategy where in the cash segment they hold the shares while selling out-of-the-money call options which will probably expire worthless. However, it can become risky to newbie investors as it can lead to huge losses if not have proper risk management.

Options can be used to hedge risks in TA projects by: Protecting Against Downside: Purchasing put options gives protection for a drop in the value of its underlying asset. Generating Income: Selling covered calls can provide some kind of income and act as a partial hedge against small price drops. Collar Strategy: Pairing the purchase of protective puts with selling covered calls can form a collar strategy, limiting both upside and downside risk.

Futures contracts are often used for risk management in TA projects: Locking in Prices: Futures contracts allow price locking for the underlying asset and thus give protection from adverse movements in prices. Specifying Future Transactions: By engaging in futures contracts, businesses can lock-in prices for future transactions that would provide protection against price volatility risks.

Real-world scenarios how the futures can be used to hedge out the investments? Suppose a person has had investments in stock for more than 2 years, but there arises a problem where he needs some funds and has to sell out his securities to get the money, he knows that if I sell out at this price have to buy out a higher price in few months according to his research. So in this case what he does is that for that same stock of equal quantity, he buys a Futures contract which locks the price on which he sold his shares for emergency funds. Big traders especially in commodities use futures contracts for metals like Gold, Silver, Wheat, and Coffee where buy physically and sell the same in exchange for the futures contract which locks the price.

Derivative instruments which are highly leveraged become risky if the person who is using not having proper knowledge of what market scenario to use it. I will use put options instead of shorting the Futures contract at uncertain times like 2008, and COVID. The buying of the put option will only give a loss of premium which I paid, but shorting of futures at the time the market is highly volatile will give me huge MTM swings and can also give me a margin call if it peaks to the deposited margins.

Options and futures offer unique tools for diversifying investments. Using options, one can create spreads—custom strategies that blend buying and selling options at different prices and dates. Spreads act as personalized risk management tools, optimizing gains and adapting to market conditions. For example, a bull spread profits from a slight asset price rise, while a bear spread gains from a moderate drop. Futures enable the formation of synthetic positions, like the synthetic long stock position. This involves buying a call option and selling a put option with identical strike prices and expiration dates, replicating stock ownership with less capital and more leverage, expanding the scope of investment opportunities.