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What are call and put options, and how to hedge your portfolio against risk?
In this short video you will learn everything about hedging, risks and options. At the end of the video, I will show you a fantastic strategy how you can secure your portfolio against extreme market movements, using a strategy that costs next to nothing.
Let’s look at a short story first…
David wants to sell a house for €500,000, near the house there is some vacant land. Two parties, Ryan and Steve are interested in buying it. Ryan wants to build an expensive resort there while Steve wants to build a low-quality school.
Mike, another guy, is interested in buying David’s house but he doesn’t have the full amount with him, and won’t have it until the end of the month. He’s worried that, David might sell the house to someone else while he’s waiting for his money. So, he gives €5000 premium, non-returnable, to David, to take the house off the market for a month.
While Mike’s waiting for his money to arrive, three things can happen.
If Ryan buys the vacant land near the house and builds the resort, it will increase the value of David’s house. Say, to 600,000 €. In that case Mike will be very happy since according to the agreement, he only has to pay 500,000 € for an asset that’s priced at 600,000 now.
The second scenario is that Steve buys that land and builds his cheap school, which will decrease the value of the house, say to 400,000 €. In that case Mike’s still locked in at the price of 500,000, so he won’t buy it. In this case his total loss is the 5000 €, the premium amount.
There’s a third scenario, where neither Steve nor Ryan buys the vacant land, which means that David’s house will be valued at 500,000.
Let me show you how you can hedge your portfolio with a cost effective strategy using options. I’ve included this example this video because, it works!
You can use a put option to hedge your investment. For instance, you have a portfolio of €100 000, and you buy a put option for €100 (the right to sell your portfolio at €95 000), since the price of the asset is greater than the strike price, it’s an out-of-the-money hedge, which makes the option cheaper to buy. Let’s see how this hedge will work.
Your portfolio falls to €60 000, but your option gave you the right to sell it for €95 000. Despite a huge drop of 40% in your portfolio’s value, you didn’t lose much.
In the second scenario your portfolio’s value goes up to €120 000, your put option for €100 expires worthless, which is a tiny loss since you just made a healthy €20 000 profit.
If you just hedge against the extreme volatility it’s not very expensive, and for a long investment horizon it is beneficial if you don’t have huge losses, the average effect makes you a winner.
Let’s take a look at what we’re up against as an investor, so when we hedge, what exactly are the risks that can we hedge against?
According to the modern portfolio theory (mpt), there are two types of portfolio risks
1. Systematic risk:
It basically refers to the market risks. You, as an investor cannot diversify away these types of risks which include events such as recessions, wars and interest rates. Even portfolio risk adjustment is unable to reduce this risk since many risk events are related to black Mondays or Fridays where the market opens at a much lower level. Systematic risk can be hedged or insured against an event with options. A good diversified portfolio needs less options (or insurance) to insure against the systematic risk.
2. Unsystematic risk:
The unsystematic risks, also known as “specific risks”, are specific to any individual stock. You can diversify away the unsystematic risks by increasing the number of stocks in your portfolio. Take a look at this graph:
It displays component of the stock’s return. These returns are not correlated with the movement of the general market.
There’s a general perception that risk is dangerous, a negative connotation attached to the term ‘risk’. As an investor you must understand risk objectively.
Hope you enjoyed the video. If you’d like to learn about our Algo Trading strategies, you can subscribe to our member’s list. Link’s in the description. At SAMT AG, We make diversified portfolio, which is a great choice against normal market risk. It provides a hedge against wild market swings, such as a drop of 30% or more. We hedge portfolios with an ‘out of the money option’, which is way cheaper since its way out of the money, but the protection it allows against unlikely events is extremely useful, your portfolio is hedged. You reap benefits of hedging as long as the market is not down, in fact you will have over-proportion or a significant advantage in your ‘risk-to-value’ ratio with our hedging strategy. When the price of your portfolio exceeds the strike price, you start making very healthy gains.