InvestorQ : I understand that options protect risk. How does that work?
Rishita Das made post

I understand that options protect risk. How does that work?

Answer
user profile image
2 years ago


An option is a right to buy or sell without the obligation to buy or sell. Let us first understand how this protection can be structured using options. If you are long on SBI then you need to ensure that you also get protection if the price of SBI falls. That can be done by selling futures. But the problem with futures is that you lock in your profits and above the level at which futures have been sold there is no profit on the cash position. A better way would be to buy a put option (put option is a right to sell). Assume that you bought shares of SBI but are afraid that the price of the stock could move down. You can protect your risk by buying an OTM put option. On the other hand, if you are short on futures then you can protect your risk by buying an OTM call option. Because options are non-linear products they can be useful in protecting risk with insurance.