Hedging 301: Financial Options
Flexible tools to manage price risk
On my shelf rests the 1994 version of Sheldon Natenberg’s book, Option Volatility & Pricing: Advanced Trading Strategies and Techniques. Highlighted phrases cover many pages while 25-year-old notes remain stuffed in the folds of the book.
The book quickly jumps into a discussion of the mathematical Greek derivatives – delta, gamma, vega, and theta. It then devotes large portions of the text to demonstrating how options can be used in multiple strategies and how to utilize your knowledge of the Greek derivatives as part of these trading ideas.
If you finished reading the last paragraph, you may be thinking, “this is going to be boring,” or “nope, don’t need to keep reading this technical post.” Don’t worry. Many people feel the same way when the topic of financial options comes up.
Hedging 301: Financial Options
Hedging 101 was our attempt to answer some of the questions we have received about hedging over the years. We wanted to “keep things simple” while providing the basic building blocks of hedging terms and concepts.
In Hedging 201, we went a little bit further, exploring concepts like forward curve structures and time spreads, and how understanding these concepts can help assess hedging risks.
What we want to do in Hedging 301 is to take a look at financial options. We want to clearly explain. . .
- what financial options are
- how they can be used
- and how you can integrate them into your business (without the math jargon).
Financial Options – A Basic Definition
Let’s look at a basic definition of a financial option. Merriam-Webster defines the word option this way: “an act of choosing; the power or right to choose.” If we combine those ideas with the word financial, we can define a financial option as the “ability to choose a financial outcome.”
Choosing a financial outcome sounds great! And it is. . . but we must remember two important details:
- Nothing is free.
- No outcomes are guaranteed.
These two facts let us know that a financial option has a cost, and while it might allow us to achieve a certain financial outcome, it does not guarantee that outcome.
Conclusion
Let’s combine our basic definition from above – “the ability to choose a financial outcome” – with some of the building blocks we learned way back in Hedging 101. In the second post in that series we identified two different types of risks: fixed price and market risk. Both risks could cause margin erosion, which is something no business wants to experience.
Could using a financial option to manage one (or both) of these risks help us achieve the outcome we desire?
This is the main question we will attempt to answer in this Hedging 301 series. We want to outline what financial options truly are; show how they can be used; and then demonstrate how they can work to ultimately provide the desired outcome for your business.
Keep watching over the coming weeks as we explain financial options with minimal math jargon and maximum practical application!
Hedging 301: Financial Options
By JD Buss
