Trading futures of stocks, indices or commodities is a high risk activity with potentials of unlimited loss or profit. Fortunately, with plenty of options being traded actively across all stock exchanges, traders can now hedge their risks of open futures contracts by writing call or put options on the same underlying stock, index or commodity.
A great thing about writing options is that they expire with time, and so the premiums on options gradually decreases as the expiry date approaches. Most online brokerages’ websites offer a calculator tool that you can use to calculate the price of a particular option. So, before actually writing an option, you can calculate the option premium on various days nearer to the expiry date, presuming the index or stock price to rise or fall according to your estimates.
Now, I will illustrate by taking an example of a market index called the S&P CNX Nifty, that is traded on the National Stock Exchange of India. This index is a weighted average of the fifty most actively traded stocks on the NSE sgx nifty futures.
Charting the Nifty is a good way to take a view on the index. Let us say that we believe the Nifty to be in a bearish trend. To take profits from this view, we would of course want to sell the Nifty futures for this month of May whose expiry happens to fall on the 26th day. This trade has the potential for both unlimited profit and loss.
A good idea to limit the loss in case Nifty rises would be to sell put options on the Nifty. This action would put some cash depending on the premiums available on Nifty put options. So, if we had shorted the Nifty at 5650, we could hedge the short position by writing the 5500 strike put options. If Nifty does indeed rise from 5650, we are covered against loss on our short positions in Nifty futures equivalent to the cash received on selling the put options.
This strategy would also limit the potential for profits on the downside. The maximum profit on this combination of futures and options can be calculated as the sum of the premium received and the difference of strike price and the value at which futures were shorted.
Another strategy would be to simply buying call options of a higher strike, so that the potential of unlimited loss on the upside is checked. However, since our perception on the Nifty is bearish, it would be more prudent to work on covering the loss potential on the downside by selling put options.
There can be more combinations to create strategic positions with an objective to limit risk of loss while maximizing profits, and trades can experiment with various techniques.