InvestorQ : Does the hedge really protect the investor?
Sam Eswaran made post

Does the hedge really protect the investor?

Answer
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swati Bakhda answered.
2 years ago


As can be seen from the above illustration, on the downside the maximum loss is limited to Rs.(-14) while the upside profits are unlimited. That is because the maximum loss on the option is limited to Rs.4 which is the premium that you have paid on the option. That is your maximum loss on the option, irrespective of how high the stock goes. On the upside, once your option premium cost of Rs.4 is covered; your net profits start at that point. But what about the downside risk?

Remember, a put option is a right to sell. When you buy the Tata Motors 370 put, you are actually buying a right to sell (without obligation) Tata Motors at Rs.370. So, you have a loss of Rs.10 on the transaction (380-370), which is the difference between the price at which you bought the stock and the price at which you bought the put option. To that you add Rs.4 which you paid as option premium as that is your sunk cost. That gives you a total loss of Rs.(-14), which is the maximum loss you will incur, even if the stock price of Tata Motors goes down all the way to Rs.100.

But what should you do once the option expires? If the price movement is against you then you can just close out the stock and the option and book a maximum loss of Rs.(-14). Alternatively, you can book profits on the put option once the stock price reaches close to the support. If you don’t want to do either of these things, then you can just keep buying a new option every month and that will entail you a cost of around 1% per month.