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What are the Advantages of Hedging with an out-of-the-money Put Option?

Hedging with an out-of-the-money put means that the hedger does not protect himself against the current share price level, and instead purchases a put with lower exercise price.

Just like with a partially comprehensive insurance cover, the insurer has to provide a deductible.

Advantage:Hedging with an out-of-the-money put is much cheaper than hedging with an at-the-money put, as the premium of the put can be significantly lower (depending on the exercise price selected).
Disadvantage:The hedge takes effect later.

Scenario

To hedge a equity portfolio of 500 German XY shares the hedger needs 500 "rights to sell".
Current share price: EUR 50.
Exercise price of the option: EUR 45.
Five XY put contracts are bought.

Insurance premium:

EUR 0.50 per share, Total: EUR 250

Depending on the share performance, different scenarios (per share) are possible when the options expire.

Share price upon expiration of the option Profit/loss on the shares Profit/loss on the puts Result share + put
60 +10 -0.50 +9.50
55 +5 -0.50 +4.50
50,50 +0.50 -0.50 0
50 0 -0.50 -0.50
48 -2 -0.50 -2.50
45 -5 -0.50 -5.50
40 -10 +4.50 -5.50

The insurance is equal to an emergency insurance. When expecting a strong increase in market prices, the investor buys a cost effective, in the money lying insurance in order to be hedged against a strong decline in market prices.

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When using a put with a low exercise price for hedging purposes, the maximum loss increases by the portion of loss to be borne by the hedger, which is a maximum of EUR 5.50 per share in our example.

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