Note: this is the third article in our enlightening series, “Mastering Options Trading with Carmine Options AMM: A Guide for Retail Users.” The First and Second edition can be found on our Medium page.

Having explored the basics of options trading and the intricacies of options pricing, we now shift our focus towards strategic application. Specifically, we’ll delve into how you can use options to hedge your positions, providing protection against potential investment risks on rainy days.

Understanding Hedging

In the world of finance, hedging refers to strategies used to offset potential losses in one investment by making an additional complementary investment. In the context of options trading, options can be utilized to limit the risk associated with a particular position.

Using Put Options for Hedging

One of the most common ways to use options for hedging is by buying a put option. If you own a token that you believe may drop in price in the short term but you don’t want to sell it, you could buy a put option. If the stock price does drop, the put option will increase in value, helping to offset the loss in the underlying token.

Using Call Options for Hedging

Conversely, if you wanted to protect against a potential increase in the value of a token that you don’t own (perhaps you’re planning to buy it soon), you could buy a call option. If the token price rises dramatically, your call option would increase in value to offset the higher cost of buying the token.

Creating a Protective Collar

A protective collar is another hedging strategy that involves holding the underlying token, buying a put option, and selling a call option. This strategy creates a ‘safety net’ of sorts by establishing a protected price range for the underlying token.

The benefits of implementing a protective collar strategy are numerous. First, it offers downside protection. If the price of the underlying token falls, the put option increases in value, offsetting the loss. Second, this strategy can be cost-effective. By selling a call option, you can offset the cost of buying the put option, potentially allowing for the hedge to be established for little or no net cost.

However, it’s important to note that a protective collar also caps the upside potential to the strike price of the call option sold. This means that if the underlying token’s price rises significantly, the profit will be limited to the strike price of the call option sold minus the token’s price when the options were initiated, plus the net premium received or paid.

Benefits and Risks of Hedging with Options

While hedging with options can be a powerful way to protect against losses, it’s important to understand that it also involves risks. The cost of options can reduce your overall return, and if the hedged token increases in value, you may lose out on some potential gains. However, for many investors, the benefits of risk reduction outweigh these potential downsides.

Conclusion

The world of options trading offers a wealth of opportunities for savvy retail investors. Whether you’re seeking to hedge your positions or implement other advanced strategies, understanding how to effectively use options can provide significant benefits. Stay tuned for the next instalment in our series, “Mastering Options Trading with Carmine Options AMM”, where we’ll continue to explore the vast landscape of options trading.