Financial Markets For The Rest Of Us
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds
In those cases a decline in the share price or making margin interest payments could wipe out the proceeds from the covered call and them some.
There is yet another important type of risk management that options provide, and by some accounts the majority of options are purchased or sold to take advantage of this risk management technique: hedging. Hedging in general refers to a trading strategy to minimize risk from another trade. A hedge is normally a trade that is somewhat the opposite of the first trade, and thereby it provides a measurable protection against potential losses from the first trade. Don't worry if this sounds confusing. It will be clear to you in a short time.
Most of us are involved in hedging throughout our lives. If you have ever bought insurance, you have hedged without even knowing. How? Let's say you have a homeowner's insurance. Your first investment has been your home. And the potential loss is losing your home (e.g., due to fire, flood, earthquake, etc.). The hedge is the premium you pay for an insurance policy to protect you against losing your home. The insurance costs you money, but you would lose a lot more if you ever lose your uninsured home to fire. What I meant by the hedge being somewhat the opposite of the first trade can also be illustrated here. Your insurance policy will not even pay you a cent while your first investment (your house) is safe and sound. The only way you would ever receive money from your hedge (in this case, your insurance policy) is when you incur losses with your first investment (your house). Considering the protection received from a homeowner's insurance policy, most of us gladly pay the premium. …
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