Overview of Option Hedging Rules
Option hedging aims to mitigate or reduce risk rather than chase profits. Investors typically use options to protect existing or anticipated asset positions against price volatility. Hedging is also referred to as risk neutralization or portfolio insurance.
Key Hedging Strategies
Equal-Weight Hedging (1:1 Ratio)
- Simplest method, matching option value 1:1 with the underlying asset.
Examples:
- Covered Call: Sell a call option against owned stock. Limits upside but generates premium income.
- Protective Put: Buy a put option to insure against downside risk.
Static Delta-Neutral Hedging
- Adjusts hedge ratio based on the option’s delta (e.g., 1:Δ).
- Rebalancing occurs only during rollovers (e.g., at expiration).
Dynamic Delta-Neutral Hedging
- Continuously adjusts positions when underlying price moves beyond a threshold (e.g., ±1%).
- Maximizes risk mitigation but increases transaction costs.
Selecting Options for Hedging
Critical factors include:
| Factor | Consideration |
|----------------------|-----------------------------------------------|
| Expiration | Align with hedge duration; prefer near-month contracts. |
| Strike Price | Balance cost (premium) vs. protection level. |
| Liquidity | Avoid deep ITM/OTM options; near-ATM preferred.|
👉 Explore advanced hedging tactics
Case Study: Hedging Hang Seng Index with Dynamic Delta-Neutral Strategy
Scenario:
- Investor holds HKD 10M Hang Seng stock portfolio.
- Buys 1% ITM put options, adjusting positions when index moves >1%.
Results:
- 7 adjustments over 3 weeks due to market volatility.
- Net gain: 1.46% despite underlying asset loss of 11.08%.
Practical Challenges
Volatility Sensitivity:
- Rising volatility benefits protective puts; hurts covered calls.
Margin Requirements:
- Covered calls may require margin; protective puts tie up capital via premiums.
Transaction Costs:
- Frequent rebalancing in dynamic hedging erodes returns.
FAQs
Q: Which hedging strategy is best for long-term portfolios?
A: Static delta-neutral hedging balances cost and effectiveness for extended periods.
Q: How does liquidity impact option selection?
A: Low liquidity in far-month or extreme-strike options complicates execution.
Q: Can hedging guarantee profit?
A: No—hedging aims to reduce risk, not ensure gains.