There are many useful strategies for managing exposure to the market with option trading, but there is a special place that option hedging strategies occupy because these techniques allow traders to hedge positions while still maintaining profit prospects. Most traders stop at the somewhat familiar protective put or covered call, but hedging takes far more than these simple setups.
This article now takes you through three underused combinations in option trading, how they function, and when they can actually be put to good practice.
- Ratio Put Hedge
The ratio put hedge involves holding a long position in the underlying stock or index while buying and selling puts in unlike quantities. Typically, a trader keeps one put option close to the price point of the market and sells two or several others at a lower strike.
How It Works:
The purchased put provides upside protection at the cost of the lease rate, whereas the further sold puts generate income to offset this expense. The strategy creates reduced net outflow and is used to safeguard against moderate decreases.
When It Works:
This hedge is best placed in mildly bearish markets into which the trader expects limited downside. A severe fall in the underlying produces liability on the additional short puts, making careful monitoring necessary.
Key Consideration:
Margin requirement will go higher due to the uncovered put exposure. Therefore, traders should only use this option if they have adequate capital and conviction about limited downside risk.
- Collar with a Twist
This is the classical collar that whenever you have an ownership in the underlying asset you buy a protective put option, and then sell a call at a higher strike price at the same time to fund the hedge. An alternative mode of this strategy adds a second leg by selling a put at a much lower strike for the creation of what sometimes is called a “syntheticly funded collar.”
How It Works:
The long put provides protection near current levels reading, and the short call offsets the cost. Adding a second short put far below the market generates extra premium bringing net costs lower even further.
Works When:
This suits sideways to moderately bullish markets. The investor locks a range for protection while minimising the net premium outflow. That short put should typically not get exercised unless the market falls off significantly.
Key consideration:
If the market should drop heavily, the additional short put can result in unexpected losses. Hence, this hedge is suitable only for traders comfortable with taking delivery or holding reserves for margin adjustments.
- Calendar Spread Hedge
A calendar spread usually aims to profit from time decay, but it can also serve as a hedge. Here, a trader essentially holds a short position in the underlying for a certain time period and buys long options further out by staggering near-term options sold at the same strike.
How it works: The long-dated option ensures coverage against adverse movements, while the short option generates premium income. The structure protects the trader during sudden volatility spikes because the long option retains value longer than the short option.
Whens the Hedge is Effective: This hedge benefits when a trader expects relatively severe noise over the near term but with a longer exposure attached to it. For instance, such noise would typically occur just before earnings announcements or before major macroeconomic events.
Key consideration: Close vigilance is essential on the sucking in calendar hedge to implied volatility. If volatility contracts, instead of expanding, the hedge may underperform.
These Combinations Matter
All three mentioned options hedging strategies obviously have a common denominator in balancing protection against cost efficiency. Not easily set up, traditional outright hedges such as the outright puts are often very expensive. Sell options or use time spreads in order to lower costs but still give the option benefit with regard to risk control.
However, they come with trade-offs. Indeed, sold options may attach obligations that, under very unfavorable market conditions, end up resulting in huge losses. Hence, these forms of trading work best for traders who:
Have a clear market view.
Are knowledgeable enough to manage the positions busy.
Maintain sufficient margin availability.
Practical Takeaways
Ratio Put Hedge-Probable in the event of moderate downside but with slight reduction of the premium costs.
Collar with a Twist — Operate in stable or slightly higher bullish markets although with risk at lower strikes.
Calendar Spread Hedge-best where you want to hedge against short-term volatility while still carrying long exposure on your account.
No, it’s about removing risk: it’s about hedging correlating with pragmatic expectations. For, at the end of the day, options are about probabilities consonant with a person’s attitude to risk rather than certainties.
Conclusion
Going beyond standard protective puts and covered calls can expose and develop entirely new ways to manage exposure in option trading. Ratio put hedge, modified collar, and calendar spread hedge each show how flexibility with option hedging strategies can help balance costs against risks. When used with some thought, these methods protect against downside risk while giving the trader a chance to remain in the markets.
