Options are a type of derivative security that gives the holder the entitlement, but not the duty, to purchase or trade-in an underlying asset at a set price on or before a given date. You can use options for risk management. They can hedge against losses in a portfolio by buying protection input options or speculating on price movements by buying call options. Saxo has a range of different options you could choose from.

Hedging

One way traders can use options for risk management is by hedging their positions. Hedging involves buying protection in the form of put options to protect against a possible decline in the price of the primary asset or buying call options to protect against a possible increase in the underlying asset’s price.

For example, imagine that you are long 100 shares of BP, and the stock starts to decline in price. You could buy a put option below the current market price of BP, which would give you protection against further losses if the stock continues to decline. Alternatively, if you were expecting the price of BP to rise, you could buy a call option above the current market price of BP, which would give you the right to buy BP at a higher price if the stock rises in price.

Speculation

Another way traders can use options for risk management is by speculating on price movements. Speculating on price movements involves buying call options when you expect the price of the underlying asset to rise or buying put options when you expect the underlying asset’s price to fall.

For example, imagine that you are expecting the price of BP to rise in the future, and you buy a call option with a strike price of £4. If the price of BP rises to £5, your call option will be worth £1 (the difference between the strike price and the market price). However, if the price of BP falls to £3, your call option will be worth £0 (the strike price minus the market price).

Leverage

Leverage is another way that traders can use options for risk management. Leverage allows traders to control a more prominent position size with smaller capital, resulting in more significant profits or losses.

For example, imagine that you have £1,000 to invest, and you buy a call option with a strike price of £4. If the stock rises to £5, your call option will be worth £1 (the difference between the strike and market prices). However, if the stock falls to £3, your call option will be worth £0 (the strike price minus the market price).

Limited Risk

Another benefit of using options for risk management is that they offer limited risk. Unlike buying the underlying asset outright, buying an option limits your maximum loss to the price you paid for the option.

For example, imagine buying a call option with a strike price of £4. If the stock rises to £5, your call option will be worth £1 (the difference between the strike and market prices). However, if the stock falls to £3, your call option will be worthless. In this case, you would have only lost the £1 that you paid for the option.

Tax Benefits

Another benefit of using options for risk management is that they offer tax benefits. When you buy an option, you can deduct the cost of the option from your taxable income. It can result in savings of up to 50% on your taxes.

For example, imagine buying a call option with a strike price of £4. If the stock rises to £5, your call option will be worth £1 (the difference between the strike and market prices). However, if the stock falls to £3, your call option will be worthless. In this case, you would have only lost the £1 that you paid for the option. However, because you are allowed to deduct the cost of the option from your taxable income, you would only be required to pay taxes on £500 of profits (£1,000 – £500).