How to Hedge an Options Strategy

Although there are other traders in the market, chances are that when you place an options trade, the person or entity on the other side of that trade will be a market maker.

Market makers do as their name implies. They’re employed by options exchanges to “make a market.” They provide liquidity so that traders can readily enter and exit their positions.

Without liquidity, options traders will simply stay away.

Market makers provide liquidity by quoting prices and volume on both 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, irrespective of their underlying view of the market.

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 share price is going to rise and you decide to buy a call option, it is a market maker selling you that call.

And in doing so, they are taking on the obligation of handing over those 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 multiple times over multiple stocks is how they make their money.

But what happens if, after writing that call, the stock price rallies strongly like Nvidia (NVDA), for example?

A market maker who wrote NVDA call options at say, $200, $300, or even $400 would be set for unimaginable 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.

And this is how market makers protect themselves against massive potential losses.

Replicating Another Position

To best understand how market makers hedge themselves, you need to think about how they might take out 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 $500, and I buy an at-the-money (ATM) call option. That gives me the right to buy NVDA stock at $500 up until the option expires.

If the NVDA stock price tanks, the most I lose is my premium. And the market maker banks the money.

But what if the stock price takes off and is trading at $600?

The market maker still has to hand over the shares to me at $500 if I exercise my call option.

Market makers can protect themselves by buying the equivalent number of NVDA shares at the same time they’re selling me the $500 call options.

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 the NVDA stock price tanks, the market maker is going to lose money on those shares. Theoretically, those shares have the potential to 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 is 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 has now written the call option at $500 and bought the equivalent number of NVDA shares at $500. They also need to buy a $500 put option to complete their hedging strategy.

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

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

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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