How Options Help With Hedging

By Larry Benedict, editor, Trading With Larry Benedict

Chances are that when you place an options trade, the person on the other side of that trade will be a market maker.

Market makers do as their name implies. Options exchanges employ them to “make a market.” They provide liquidity so traders can easily enter and exit their positions.

Market makers provide liquidity by quoting prices and volume on the buy and sell sides of call and put options with different strike prices and expiry dates.

And if you “hit” them, they’ve got to take the trade, no matter what their underlying view of the market is.

So they use options strategies to hedge against potential losses.

Let’s take a look…

Taking on Obligations

For example, if you believe that a stock is going to rise, you might decide to buy a call option. It’s a market maker selling you that call.

In doing so, they’re obligated to hand over 100 shares if you exercise your option.

If the underlying share price trades sideways or falls and your call option expires worthless, the market maker simply banks the premium.

Doing this many times with different stocks is how they make their money.

But what happens if, after writing that call, the stock price rallies strongly?

A market maker who wrote NVDA call options at $130, $140, or $150 this year would be set for hefty losses if they didn’t somehow hedge their positions.

However, one of the great things about options is their flexibility.

They offer numerous strategies. And you can use those different strategies to offset an underlying position.

Let’s look at how market makers protect themselves against massive potential losses…

How Market Makers Hedge

To best understand how market makers hedge themselves, you need to think about how they might take the opposite position to the one they just opened.

So let’s run with our NVDA example.

Let’s say that NVDA is trading at $140, like it did early this year. I buy an at-the-money call option. That gives me the right to buy 100 shares of NVDA stock at $140 up until the option expires.

If the NVDA stock price tanks, the most I lose is the premium I paid when I bought the option. And the market maker banks that money.

But what if the stock price takes off and is trading at nearly $160, like it is now?

The market maker still has to hand over the shares to me at $140 if I exercise my call option.

Market makers can protect themselves by buying 100 NVDA shares at the same time they’re selling me the $140 call option.

That way, they’re covered no matter how high the NVDA price goes and can fulfill their obligations.

But something is missing…

Understanding Risk

If NVDA tanks, the market maker is going to lose money on those shares. Theoretically, those shares could go all the way to zero.

On the other hand, I (the call option buyer) have limited risk. The most I can lose is the call option premium.

So there’s not an equivalent risk between both positions, which is vital to any hedging strategy.

That’s why the market maker needs to add another leg to their long shares position: a bought put option.

The market maker wrote the call option at $140 and bought 100 NVDA shares at $140. They also need to buy a $140 put option to complete their hedging strategy. That way, they can sell 100 shares at $140 until the option expires.

Now their position has the same risk/reward profile as my bought call position. It acts as a hedge against their written call option position.

The beauty of options is that you can use this and other combinations to create (and hedge) many strategies.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict