Trading stock, index or commodity futures is a high-risk activity with unlimited profit or loss potential. Fortunately, with many options being actively traded on all stock exchanges, traders can now hedge their risks from open futures contracts by writing call or put options on the same underlying stock, index or commodity.
The nice thing about writing options is that they expire over time, so option premiums gradually decrease as the expiration date approaches. Most online brokerage websites offer a calculator tool that you can use to calculate the price of a particular option. Therefore, before you write an option, you can calculate the option premium several days closer to the expiration date, assuming the index or stock price will rise or fall based on your estimates.
Now, I will illustrate this by taking an example of a market index called S&P CNX Nifty, which is traded on the National Stock Exchange of India. This index is a weighted average of the fifty most traded stocks on the NSE.
Plotting the Nifty is a good way to get an overview of the index. Let’s say we believe that Nifty is in a downtrend. To profit from this view, we would of course want to sell the Nifty futures for this month of May which expire on the 26th. This trade has the potential for unlimited profits and losses.
A good idea to limit the loss in case Nifty rises would be to sell put options on Nifty. This action would put up some cash depending on the premiums available on Nifty’s 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 the Nifty does rise from 5650, we are hedged against losses on our short Nifty futures positions equal to the cash received. when selling put options.
This strategy would also limit downside profit potential. The maximum profit from this combination of futures and options can be calculated as the sum of the premium received and the difference between the strike price and the value at which the futures were sold.
Another strategy would be to simply buy call options at a higher strike price, so that the potential for unlimited loss to the upside is verified. However, given that our sentiment on the Nifty is bearish, it would be more prudent to work to cover the potential downside loss by selling put options.
There may be more combinations to create strategic positions with the aim of limiting risk of loss while maximizing profit, and trades may experiment with various techniques.
Ultimately, you can find a trading style that best suits your risk appetite and works best for you.