Part 3 Institutional Trading

Role of Options in Hedging

Options are commonly used to hedge portfolios against adverse market movements:

Protective Put for Stocks: Investors holding equities can buy puts to protect against downside risks.

Portfolio Insurance: Institutions use options to safeguard large portfolios against market crashes.

Income Generation: Covered call writing allows long-term holders to earn additional income while maintaining exposure.

Hedging with options is especially popular in volatile markets where risk management is critical.

Pricing Models and Market Mechanics

Professional traders often rely on option pricing models, like the Black-Scholes model, to determine fair premiums. These models factor in:

Current price of the underlying asset

Strike price

Time to expiration

Volatility

Risk-free interest rate

Options markets operate through exchanges with standardized contracts. Market makers provide liquidity, and the bid-ask spread reflects supply-demand dynamics. In OTC markets, options can be customized to suit specific investor requirements.

Advantages of Options Trading

Leverage: Control a larger position for smaller capital.

Flexibility: Strategies for bullish, bearish, or neutral markets.

Hedging: Effective risk management tool.

Profit in Any Market: Can profit in rising, falling, or sideways markets with the right strategy.

Defined Risk (for Buyers): Limited to premium paid.

Challenges and Considerations

Complexity: Options require understanding of multiple factors affecting pricing.

Time Sensitivity: Options lose value as expiration nears.

Volatility Risk: Price swings can be unpredictable.

Liquidity Issues: Not all options have sufficient trading volume.

Psychological Pressure: Rapid movements and leverage can lead to emotional decisions.