How Hedge Funds Can Use Options to Reduce Risk

How Hedge Funds Can Use Options to Reduce Risk
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How Hedge Funds Can Use Options to Reduce Risk

Investing in any sort of capacity can entail quite a bit of monetary risk. Hedge funds are no different, even if they are designed to alleviate the risk from high profile investors’ other investments. Just because a hedge fund is supposed to make money when other markets might be losing money does not mean that they will always perform at a high capacity for profits. Hedge funds lose money, too, at times.

There are many things that hedge fund managers do to help minimize the risk that their funds take on. One such move can be the use of options. An option gives an investor the right, but not the obligation, to purchase a set of stocks or other asset at a previously agreed upon price. The way they work is quite simple. By extrapolating the price of an asset further down the road, you can sometimes find really good deals if the asset moves more than the final agreed upon price.

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For example, if you think Apple’s stock will be at $700 one year from now, you might decide to buy an option for 1,000 shares of Apple at $675 right now. If the price goes up to $700, you can exercise your right to buy those 1,000 shares at the lower price and then immediately sell them for a profit of $25 per share. If the price doesn’t move enough to make exercising the option attractive, you are only going to lose the price you paid for the option contract.

You can see how this could be a good way to reduce risk for a hedge fund manager. There is a lot to gain if the price moves in an aggressive fashion and there isn’t a lot to lose if you are wrong. For people looking to make big gains, this can be a great tool. Hedge fund managers can help produce big results for the clients that trust them by using options in this manner. If they are wrong, there is a loss associated with the failed option contract, but this is only a nominal amount in comparison to actually buying the shares of stock and losing money upon them.

Options might not be as accessible to the average trader as they are to fund managers. In order to buy an option contract, you are responsible for paying the cost of the contract to an options broker. The problem here is that the contracts are usually for large amounts of shares. The contract price per share will vary from broker to broker and will be dependent upon the length of time before the contract expires and the amount of movement that you are getting. This can be quite costly for the average investor, even if they are wealthy.

A collective fund, such as a hedge fund, can pool together many investors’ money and make options contracts much more feasible to their clients. This way, they can take advantage of the great benefits that options bring with them without having to front as much money as they might need to if they were doing it on their own. Pooling money together gives investors many more choices of where to put their money than they would have if they were simply to invest on their own with a limited amount of capital.

Hedge funds are not as tightly regulated as things like mutual funds are. This gives their managers a lot more leeway when it comes to choosing which assets to invest in. An option creates a good way to alleviate risk since the potential for returns will usually outweigh the cost of the contract. However, options do not always pan out so there is some risk associated with them. This means that a hedge fund manager utilizing an options strategy will need to do quite a bit of research and forecasting in order for this type of investing to be beneficial to their clients.

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