Understanding Hedging: put options, call options and future contracts

Hedging is a means of mitigating risk that arises out of potential losses in investments by taking an opposite position in a related asset. This does not come without a come and can reduce potential profits. Hedging strategies typically employ the use of derivatives which can include options and futures contracts.

The easiest way to understand hedging is by taking into example a personal asset that has high value, such as a house. To 'hedge' the risk of an unforeseen event incurring a high cost on this asset you may take out insurance; a position in a related asset. By investing in insurance you protect your own personal investment.

In financial terms this is more complex and can involve the use of put options, call options and futures contracts. We will consider each of these in turn.

Put options

A put option is a derivative that enables its owners the right (but crucially not the obligation) to sell a specified amount of an underlying security at a specified price at a specified time period. The specified price is known as the strike price. The below explains a put option. 

Typically, the value of a put option is subject to deflationary pressure as time passes due to the impact of time decay. This is the chance of the stick falling below its strike price as time goes on. As the time period goes on, the intrinsic value is left over which is the differential between the strike price and the stock price. For example if the strike price is £300 and the stock is currently being traded at £290 then there is £10 of intrinsic value. This means the put option is in the money (ITM). Typically, a premium would also be attached as there is still a chance that the stock could fall lower than its current trading price which mean the put option can be sold for, say, £15. Different put options on the same stock can be combined to form put spreads. 

Call option

A call option is pretty much a put option but in reverse. So, this means an investor might purchase a call option to gain the right, via a financial contract, to buy a certain asset at a specified price within a given time period. Like a put option this is not an obligation but instead, a right. Whilst a put option buyer profits if the stock falls beyond the strike price a call option buyer profits when the underlying asset increases in price. 

The below explains how a call option works. 

Futures Contracts

A futures contract can be used to hedge a firm against potential changes in prices from suppliers. For example, if Dunder Mifflin is purchasing its paper for £2 a kg from Lumberjacks sheets. At this price, Lumberjacks sheets profits on every bit of paper it sells to Dunder Mifflin and Dunder Mifflin profits on every bit of paper it sells to its clients. If the paper market gets more saturated and Lumberjack sheets is now competing with ManySheets this means there is a downward pressure on the cost of paper to Dunder Mifflin which can now enjoy greater profits as the price drops from £2 to £1.50. However, this puts pressure on Lumberjacks sheets. 

However a rare disease that kills trees at a extraordinaire amount now materializes which in turns puts an inflationary pressure on the price of paper - pushing the price from £1.50 to £4.00. Therefore, Dunder Mifflin profit quickly turns to loss due to the change in the price of paper. 

Either scenario is hardly ideal for the two parties; and to hedge against this volatility they turn to a third party; an investor. They arrange a contract in which if the price of paper falls below £2 for Lumberjack sheets then the investor agrees to pay the difference to Dunder Mifflin, if it goes above £2 then the investor can keep the difference. The opposite arrangement goes for Dunder Mifflin, if paper goes above £2 then the investor will pay the difference allowing Dunder Mifflin to enjoy a stable price of £2 - however if the price drops below the £2 then the investor can enjoy the difference. 

By locking in at this price the two companies have effectively passed on the risks - and potential rewards - to the third party; the investor. 

This can also be applied in a more pure "financial sense"; consider the below:

A futures contract in this sense is a forward financial contract agreed between a buyer and a seller of an asset. They would agree to purchase X amount of Y at Z time despite arranging this on that moment in time. These assets can be commodities, currencies, metals and indexes. These are typically sold to shield or 'hedge' investors or companies from volatile prices. 

To start a trade in a futures contract a investor has to decide on what asset he/she wishes to trade in and then proceeds to make a marginal deposit to a broker. The broker will place this money with a clearing house, however a maintenance margin is required to keep the account active which incurs an additional price. Consider a forward contract that is based on oil; one contract covers 100 barrels of oil. The contract price is £10 per barrel, requires a margin deposit of £500 and a maintenance margin of £400. 

Therefore: 

• The  initial margin deposit would be £1,500 
• The initial maintenance margin would be £1,200 

If the price of an oil barrel increased by £33 --> £35 then the investor would gain 3 contracts * £2 (change in price) * 100 (barrels per contract) then the buyer would have gained £600. 

If instead it decrease by £2 then the investor would have lost £600. The investor would then have to resubmit £600 of variation margin in the margin deposit account to get it back to its first level. 

Another example is given below in the form of pictures: