Uses of Options & Futures in Financial Hedging

Financial hedging is a method for protecting invested assets from risk. Investors use it to reduce the potential money that they might lose on their outstanding positions. Many traders use options (and futures options) to reduce their risks. An option can be used to ensure that a trader will only potentially lose a certain amount of money on any trade. Options are securities that give the buyer the right (but not the obligation) to purchase or sell a certain security at a certain price (the "strike price") before an expiration date. Put options give the holder the right to sell a security while call options allow them to buy it.

The Protective Put

The most common options hedging strategy is called a "protective put." To exercise this strategy, you buy a security at a certain price. When the security rises in value, you then purchase a put option for that security at a point that guarantees your profit. If the security then drops below the strike price of your protective put, you can then exercise the option and sell the security at a profit. This locks in your gains at a modest price.

Another options hedging strategy is the "covered call." Investors will write a call option on a particular security that they expect to stay below a certain price. As long as the security remains below the strike price of the call, the investor will receive a premium. If the security does rise above the strike price, the writer will be forced to sell the security at a higher price to the current options holder, losing money on the trade.

Few investors actually purchase futures contracts directly because those obligate the holder to purchase large amounts of a commodity at a certain date. Instead, they purchase futures options. Futures options are used to hedge against other holdings in commodities or commodity-related stocks. For example, if an investor has large holdings in oil company stocks, he may purchase oil futures options (either protective puts or covered calls) to allow him to still make money on his investments even if the oil stocks fall in value.