Derivatives: introduction to options: hedging a derivative
There is a fair degree of risk or exposure for the writer or issuer of an equity derivative such as an option, future, warrant etc, as he will not generally know whether the holder will exercise the derivative any time within the agreed time period. Commonly, the issuer will not have the required quantity of shares in the underlying security at the time when the option is written or during the period of the option, to satisfy or cover say, a call option that may be exercised by the holder. These are called uncovered options.
In this situation, option writers can minimise their risk or exposure by:
- purchasing sufficient quantity of the underlying shares during the period of the option, or more frequently,
- offsetting their exposure on the written call option by say, purchasing a call option from another exchange member.
This mechanism of minimising risk is called hedging.
For further information on the ‘exercise’ of an option see STSM112050
For information on equity derivatives, see STSM111020
See STSM112070 for the meaning of a call option