Effective Hedging Strategies Combining Future and Options: A Guide for F&O Traders

With the growing interest in Futures and Options (F&O) among retail investors, we want to discuss a strategy that combines futures and options contracts to maximize profitability. This guide explores a popular approach: using a combination of futures and options with the same expiration date. We’ll also examine how to select futures and options for the primary and secondary components of the strategy.

Read: An Introduction to Call and Put Options

Why Use a Combination Strategy?

Combination strategies have two main benefits: they can reduce capital outlay and potentially increase profitability. Let’s say you’re considering buying a lower strike call option while selling a higher strike call option. This setup results in a lower net debit than simply buying a call. Additionally, time decay from short option positions can further increase profitability.

Suppose you expect an underlying asset to increase in value. Your goal is to capture as much of that price movement as possible. Futures contracts tend to move more closely with the underlying asset compared to options, which makes them ideal for capturing price fluctuations. This forms the basis for our first argument: for a combination strategy, the primary position should be in futures.

Setting Up a Combination Strategy

If you have a positive outlook on an asset, consider taking a long position in futures as your primary strategy. Conversely, if you’re bearish, a short position in futures is preferable. This allows you to capture the most value from underlying price changes in your chosen direction.

Options as Secondary Positions

After establishing your primary futures position, the question arises: should you add a put or short a call to complement your long futures position? Some traders prefer using puts as a hedge, but this approach has limitations. Let’s illustrate with an example.

Suppose you are long on a near-month Nifty futures contract, expecting the index to rise by around 300 points to 16500 with CMP of index at 16200. You buy a next-week expiry 16300 Nifty put to hedge your position. However, if the index drops by 250 points two days before expiration, the put might be worth only 290 points, even though it cost you 270 points. This means you lose 250 points on your long futures while gaining only 20 points from the put, offering minimal hedge value.

Let’s break this down step-by-step to help you understand the underlying concepts and calculations:

Setting the Scene

1. Long Position in Futures: This means you believe the Nifty index will go up, so you enter into a futures contract to buy at a certain price, expecting to sell it later at a higher price. The current market price (CMP) of the Nifty index is 16200. You expect it to rise by 300 points, reaching 16500.
2. Buying a Put for Hedging: You buy a put option with a strike price of 16300, expiring the next week. This is a form of insurance against a drop in the index. If the index falls, the put option gains value, offsetting some of your potential loss from the long futures position.

Scenario with Hedging Using a Put

1. What Happens When the Index Drops?: Suppose the index falls by 250 points to 15950 (16200 – 250 = 15950). You lose 250 points on your long futures position because it now has a lower value than what you expected.
2. The Put Option’s Value: The put option you bought with a 16300 strike price gains value as the index falls. But because it has only a couple of days left before expiration, its value increase is limited due to the effects of “time decay” (the closer an option gets to expiration, the less it is worth unless it’s in-the-money). Given the drop in the index, let’s say the put option is now worth 290 points.
3. Cost of the Put and Net Gain: You initially paid 270 points for this put option. With the drop in the index, the put gains only 20 points (290 – 270 = 20). So, while the futures position loses 250 points, the put hedge offers a mere 20-point gain, resulting in a substantial net loss overall.

This brings us to the second argument: using puts for hedging may not always be effective in a combination strategy. Instead, consider shorting a call.

Shorting Calls to Complement Long Futures

Suppose you short a next-week 16300 Nifty call for 230 points. If the index drops by 250 points to 16250 two days before expiration, the call could be worth only 25 points, offsetting losses on the futures position. While shorting calls doesn’t always cover your losses completely, it helps reduce them and benefits from time decay.

Strategy with Shorting a Call

Instead of buying a put to hedge, consider shorting a call:

1. Shorting a Call: This means you sell a call option to someone else. If the index drops or stays below the call’s strike price, this position gains value because the call becomes less likely to be exercised. You short a next-week 16300 Nifty call for 230 points. This gains value as time passes and the index drops.
2. What Happens When the Index Drops?: If the index falls by 250 points to 15950, the value of your short call drops significantly, let’s say to 25 points. This generates a gain of 205 points (230 – 25 = 205) from your short call position.
3. Offsetting Losses: This gain from the short call can help offset losses from the long futures position. If you lose 250 points on the long futures but gain 205 points from shorting the call, your net loss is reduced to 45 points (250 – 205 = 45).

A favorable condition to set up a long-futures, short-call strategy is when you expect the underlying asset to approach your target price near the option’s expiration date. The long futures position provides near one-to-one movement with the asset, while the short call position gains value or incurs only minimal losses due to time decay. For example, if the 16300 call is worth 250 points with the underlying at 16500 two days before expiration, you incur only a minor loss from the short call.

The key takeaway is that a long-futures, short-call strategy might be preferable over a long-futures, long-put strategy when you expect a consistent upward trend. It provides more flexibility and can cushion losses while allowing for significant gains if the asset moves as expected.

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.