Why hedged trading should be your go-to strategy over naked options trading

The article is authored by Rahul Ghose, CEO of Hedged.in.

Options trading has gained immense popularity, particularly after the COVID-19 pandemic in 2020. The allure of quick gains, ease of execution, the rise of sophisticated online platforms, and influencer marketing have collectively fostered a belief that easy money can be made in this space. However, the reality paints a starkly different picture.

Recent SEBI data revealed that most new accounts opened in the past three years belong to millennials or Gen Z. This younger cohort is more tech-savvy, earns higher salaries than their parents did at the same age, and has more disposable income. Additionally, they are more inclined to take risks and are not willing to "wait" for outcomes. In an era of instant gratification from services like Amazon, Zomato, and Swiggy, many young traders expect immediate results in the world of trading and investing as well. This impatience often leads to reckless and overzealous trading.

Trading, which should be treated like any other profession requiring education, discipline, patience, and dedication, is instead being approached like gambling. This has led to significant losses, frustration, and a waste of both time and capital. SEBI's recent data is shocking—individual retail traders collectively lost around Rs 1.8 trillion in the F&O market between March 2021 and March 2024. SEBI has been repeatedly highlighting that over 90 per cent of retail traders end up losing money, and brokers are now required to display this warning on trading platforms. Nevertheless, the lure of quick gains continues unabated.

So, should you stay away from trading in futures and options (F&O)? Certainly not. Instead, the focus should be on trading wisely and responsibly. Otherwise, these instruments could indeed become what Warren Buffett famously called "weapons of mass destruction."

An analogy I often use is: If someone doesn’t know how to drive and takes the wheel, an accident is inevitable. However, if the person has received proper training, knows traffic rules, and understands when to accelerate or brake, driving can be a pleasurable experience. The same is true for F&O trading. If one understands the associated risks, learns which instruments to trade, and adopts effective hedging strategies, trading in options or other leveraged instruments can also be a rewarding experience.

Among the many things one can do to trade responsibly, one of the most important is learning how to hedge while trading options.

What is Hedging?

Hedging, in simple terms, is like buying insurance for your trades. Just as you buy insurance to protect yourself from financial loss, in trading, you hedge to protect your positions from adverse price movements. Look at it as though, you are taking a trade as though it might go wrong. The difference is that you are preparing for this bad outcome while taking the trade itself and not at a later date.

How to Hedge While Trading in Options

Hedging in options trading is essential to manage risk and protect your portfolio from adverse market movements. Here are some effective strategies to hedge your options trades:

1. Always Buy Protection When Selling Options

Selling options comes with the risk of unlimited losses, making it crucial to buy protective options. For example:

• When you sell a call, buy another call option with a higher strike price to cap potential losses.
• If you sell a put, buy a put with a lower strike price to safeguard against excessive losses.
• By doing so, you limit your downside risk, ensuring responsible trading.

2. Trade Only in Liquid Instruments

Liquidity is key for executing hedging strategies smoothly. Always choose liquid instruments, as they offer:

• Easier trade execution without significant price fluctuations.
• Adequate market depth to ensure there are enough participants when hedging.
• Illiquid contracts may make it difficult to hedge effectively, exposing you to greater risks.

3. Assess Market Conditions Regularly

The market favours different strategies at different times, depending on volatility and broader economic trends. Instead of sticking to a fixed approach (always being a buyer or seller):

• Evaluate market volatility and implied volatility.
• Understand whether the environment favours option buyers or sellers.
• This flexibility allows you to hedge more effectively by adapting to the current market.

4. Define Your Risk Per Trade

Before entering any trade, decide how much capital you're willing to risk, whether it's 1, 2, or 3 per cent of your total portfolio. This ensures that:

• You control your exposure on each trade.
• You can plan your hedging strategies based on clearly defined risk parameters, helping you avoid larger-than-expected losses.

5. Use Options Spreads for Risk Management

Spreads, such as vertical spreads (e.g., bull call spreads and bear put spreads), are excellent hedging tools. By trading spreads, you:

• Limit potential profits, but also minimize your losses.
• Reduce the overall risk while maintaining a position in the market.

6. Apply Protective Puts for Long Stock Positions or Index ITM Leaps

A protective put acts as an insurance policy for your stock or index holdings. By purchasing a put:

• You secure protection against downward movements.
• You can still benefit from any upward price momentum, with a capped downside in case of declines. This is particularly useful for long-term stockholders who want to hedge against market corrections.

Why Do Traders Opt for Naked Options Despite the Benefits of Hedging?

Despite the clear advantages of hedging, many traders still prefer trading naked options. Here are some key reasons why:

1. Lack of Knowledge
   • Many traders are unfamiliar with hedging strategies, often due to a lack of formal education in derivatives. They may not invest the time to learn about risk management, leading them to take unnecessary risks by trading without protection.
2. Greed
   • Hedging involves costs, which can reduce overall returns. In pursuit of higher profits, some traders choose to ignore these risks and forgo hedging. However, this greed-driven approach can backfire when the market moves against them, potentially leading to significant losses.
3. Stubbornness
   • Some traders are overly confident in their market predictions, believing they cannot be wrong. This overconfidence prevents them from using hedging strategies, as they rely solely on their forecasts. In reality, even the most experienced traders can misjudge the market’s direction.
4. Past Success
   • Previous success in trading naked options can breed a false sense of security. Traders may think they can replicate their past wins without considering that market conditions constantly evolve. The saying, “Option sellers eat like chickens and shit like elephants,” emphasizes that while consistent small profits are common, a single large loss can erase those gains.
5. Large Capital
   • Some traders believe that having substantial capital protects them from significant losses when trading naked options. They assume they can absorb any losses and recover. However, market volatility is often unpredictable, and even large accounts can be quickly depleted without the safety net of hedging.

Conclusion

The importance of hedged trading over naked options trading cannot be emphasized enough. Responsible trading involves recognizing the risks and actively working to mitigate them, and hedging is one of the most effective tools for doing so. By employing hedging strategies, traders can limit potential losses, reduce exposure to market volatility, and build a more sustainable and controlled trading experience.

While the appeal of higher profits may tempt traders to engage in naked options trading, the risk of catastrophic losses makes this an extremely risky path. Trading should be approached as a skill that requires education, practice, and discipline. Just as no one would drive a car without proper training, traders should not enter the options market without understanding the risks and learning how to protect themselves through hedging.

Using a hedging strategy not only enhances risk management but also encourages a professional and disciplined mindset. Traders who prioritize capital preservation and risk control are more likely to achieve long-term success in the world of options trading.