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What are Call and Put Options? How to Hedge Portfolio Against Risk? - YouTube
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What are call and put options and how to
hedge your portfolio against risk. In
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this short video you will learn
everything about hedging, risks and
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options. At the end I will show you a
fantastic strategy how you can secure
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your portfolio against extreme market
movements using a strategy that costs
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next to nothing.
I'm Nael a licensed wealth manager at
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SAMT AG Switzerland
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Let's look at a short story first. David wants
to sell a house for 500,000 euros. Near
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the house there is some vacant land. Two
parties Ryan and Steve are interested in
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buying it. Ryan wants to build an
expensive resort there while Steve wants
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to build a low quality school. Mike's
interested in buying David's house but
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he doesn't have the full amount with him
and won't have it until the end of the
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month. He's worried that David might sell
the house to someone else while he's
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waiting for his money. So he gives five
thousand euros premium non-returnable to
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David to take the house off the market
for a month. while Mike's waiting for his
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money to arrive three things can happen.
If Ryan buys the vacant land near the
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house and builds the resort it will
increase the value of David's house say
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to six hundred thousand euros. In that
case Mike will be very happy since
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according to the agreement he only has
to pay five hundred thousand euros for
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an asset that's priced at six hundred
thousand now. The second scenario is that
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Steve buys that land and builds his
cheap school, which will decrease the
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value of the house, say to four hundred
thousand euros. In that case Mike's still
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logged in at the price of five hundred
thousand, so, he won't buy it. In this case
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his total loss would be five thousand
euros the premium amount.
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There's a third scenario where neither
Steve nor Ryan buys the vacant land
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which means that David's house will be
valued at $500,000. Regardless of what happens
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during the month the maximum loss from
Mike is 5,000 euros the premium amount.
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Now let's look at the situation using
financial goggles. Mike basically
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purchased an option from David to buy
the house at a specified price in 30
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days. Note that Mike is under no
obligation to buy the house from David
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if he changes his mind. He can simply
walk away from this whole deal, so to
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speak. Yes the 5000 euro he paid to David
in the beginning will be lost,
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those are non-returnable. In other words,
the 5000 that Mike paid to David is the
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cost of owning the right to use his
option. In financial terms Mike bought a
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call option from David which makes Mike
the owner or the holder of the call
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option while David who wrote the call
option for Mike becomes the seller or
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writer of the call option. The price at
which Mike agreed to buy the house
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should he choose to exercise his option
from David (the five hundred thousand
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euro) is called the strike price, and the
specified time of one month in which
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Mike has the right to use his option is
the expiration date. And lastly the cost
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of the option is called an option
premium. A call option is just that, an
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option, which gives the buyer of the
option the right to buy the underlying
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asset at a specified price within a
specified time. An asset generally means
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a stock, bond, commodity or other
financial instrument. For call options
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the strike price is the price at which
you can buy the asset. To fully
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understand how options operate in the
market you must know about the long and
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short positions. Long positions give you
rights while short positions give you
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obligations. For instance, if you buy or
own a call option you are long a call
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option, which means that you have the
right to buy the asset. The other side of
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the equation is if
you write or sell the call option. In
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that case you take the short position or
are short the call option. But when
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you're short, you have an obligation to
sell the asset to the long.
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In real-life trading, Mike could only be
a speculator, meaning that he's not
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really looking to buy the house, in fact,
he might be only interested in making a
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profit if the price of the house goes up.
Speculation in financial market is like
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a gamble; you could make a huge gain or
completely lose your initial investment.
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Interestingly, you can open certain
accounts in the market where you don't
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have to come up with the money to buy
the underlying asset.
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You just have to purchase the option, and
if the price goes up, your call option
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will prove that as the long in a call
option you have the right to buy the
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asset at a discount and don't have to go
the trouble of first buying the asset
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at the lower price and then selling it
in the market for a profit. You can
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simply cash in the difference in
financial markets. The asset is usually a
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stock, bond, commodity or a collection of
these in a portfolio. You must have
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figured out why people buy a call option
in financial markets, it's because when
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they think that an asset will go up in
price. For instance, a company Django's
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stock is currently trading at 45 euro
per share. Mike thinks that it'll go up.
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He buys a call option for hundred shares
from David who is the seller or call
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writer. This arrangement makes Mike long
and David short the call option. The
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strike price is set at 50 euro per share,
and Mike pays a premium of 5 euro per
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share or 500 euro in total. If the share
price doesn't go up and Mike doesn't
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exercise the call option then he has
lost 500 euro, the premium amount. Case 1,
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the stock price increases to 60 euro
before the option expires. Mike exercises
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the call option by buying 100 shares of
Django from David for five thousand euro
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in total. He then sells them on the
market at the market price which is six
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thousand euro now. He paid five hundred
euro premium plus five thousand euro for
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100 stocks, and then sold them for six
thousand, netting a profit of five
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hundred euro.
Case number two, Django's price drops to
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40 euro by the time the contract expires.
Mike will not exercise the option
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because he can buy the shares on the
open market at 40 euro per share now.
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Mike will lose his premium of 500 euro
and David will make a profit of exactly
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the same amount. There's a third scenario
if Django's stock price rises to 55 it
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will break even for mike since 50 euro
is the strike price, plus the five euro
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premium he paid for the option. Overall
Mike will lose money because he has to
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pay broker fee and other transaction
costs. Now let's look at these scenarios
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on a chart. On vertical axis we have the
profit, on horizontal the stock price.
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This point here is 50 euro the strike
price and this is the premium of 5 euro
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that Mike paid to David. Since 5 euro per
share ended up in David's pocket we have
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this 5 euro line to show his earnings. On the
expiration day if stock price is 50 euro
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or lower the call option is useless. Mike
will lose 5 euro and David will gain 5
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euro. If stock price exceeds 50 euro
Mike's call option will start to gain
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value, and at 55 it will break even.
Why? Because strike price plus the option
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premium will be equal to the stock price.
As the stock price moves above 55 David
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will start losing money while Mike will
start netting profits. Looking at this
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graph we can make some conclusions. For
instance, Mike who is long the call
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option can incur a maximum loss of 5
euro, the premium amount, while David who
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is short the call option, can make a
maximum profit of exactly 5 euros and
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that'll happen as long as the stock
price remains less than or equal to 50
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euro which is the strike price. Mike and
David have the same breakeven point at
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55. Mike can potentially make unlimited
amount of profit, conversely, David's
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potential loss is unlimited. And Mike
will exercise the option when the stock
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price crosses the strike price because
that's when it becomes profitable.
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Options trading is a zero-sum game; you
add up the profits of the long and the
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short and they will always add up to
zero.
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Mike's profit will be equal to David's
loss. For reference, when the stock price
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is less than or equal to the strike
price the call option is out of the
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money when it's the same as the strike
price it's at the money and when it
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exceeds the strike price it's in the
money, quite self-explanatory.
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Put options are the opposite
of call options. The owner of the put
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option has the right but not an
obligation to sell a specified amount of
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asset at a specified price within a
specified time. For put options the
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strike price is the price at which you
can sell the asset. Just like call option
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there are long and short positions
regarding a put option. The person who
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buys the option is long the put option
and holds the right to sell the asset
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the one who writes or sells the put
option is short the put option and has
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an obligation to buy the asset from the
long. If it seems a bit confusing just
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remember that a call option means the
right to buy and a put option means the
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right to sell and when you look at the
big picture the long and short positions
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for the two options look something like
this...
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Let's take a look at how put option can
work in the stock market.
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Mike expects the share price of Django
company to fall. He buys a put option
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from David to sell 100 shares of Django
at the strike price of 50 euro per share.
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Since Mike bought the put option he is
long the put option and David who wrote
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the option is short the put option. The
current share price is 50 and Mike pays
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an option premium of 5 euro per share.
There are three possible scenarios. The
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share price drops say to 40 euros. Mike
will exercise the put option. He will buy
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100 shares from the market at 40 euros
per share for a total of 4,000 euros, and
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he will sell it to David at the strike
price of 50 euro per share, for a total
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of 5,000 euros. His profit will be 5,000
euros that he got from David, minus 4,000
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that he bought the shares with, minus 500
euro option premium, making a net profit
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of 500 euros. Case number two, the share
price increases to 60 euros by the time
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the contract expires. The option will be
worthless since the market price is 60,
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while the strike price, the price at
which Mike has the right to sell the
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shares to David, is 50 euros. His loss
will be 500 euros the option premium and
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David will make a profit by the same
amount.
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Case number 3, the stock price drops to
45 euros. It will break even for Mike
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since the strike price minus the option
premium will be equal to the stock price.
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Again, overall Mike will still lose money
since he has to pay the broker fee and
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the likes. Looking at the graph of a put
option we can make certain conclusions.
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Mike's maximum loss is 5 euros, that is if
the stock price is greater than or equal
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to 50 euros, while his maximum gain will
be 45 euros, by subtracting premium
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amount from the strike price. And yes,
that will be the maximum loss for David,
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45 euros.
David's maximum profit will be 5 euros,
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the premium he got from Mike. Break-even
will be at 45 euros for both Mike and
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David. Put option is also a zero-sum game;
David's gain is Mike's loss. For put
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options when the stock price is less
than the strike price it's in the money,
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when it's at the strike price it's at
the money, and when it exceeds the strike
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price it's out of the money.
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In the simplest words, hedging in finance
means to decrease or to transfer the
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risk. Let me show you how you can hedge
your portfolio with a cost-effective
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strategy using options. I've included
this example in the video because it
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works! You can use a put option to hedge
your investment. For instance, you have a
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portfolio of 100 thousand euros and you
buy a put option for 100 euros, the right
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to sell your portfolio at ninety five
thousand euros.
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Since the price of the asset is greater
than the strike price it's an out of the
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money hedge, which makes the option
cheaper to buy. Let's see how this hedge
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will work. Your portfolio Falls to sixty
thousand euros, but your option gave you
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the right to sell it for ninety five
thousand euros. Despite a huge drop of
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40% in your portfolio's value, you didn't
lose much. In the second scenario your
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portfolio's value goes up to 120
thousand euros. Your put option for one
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hundred euro expires worthless, which is
a tiny loss since you just made a
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healthy twenty thousand euro profit. If
you just hedge against extreme
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volatility it's not very expensive, and
for a long investment horizon it is
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beneficial if you don't have huge losses.
The average effect makes you a winner.
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Let's take a look at what we're up
against as an investor, so when we hedge
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what exactly are the risks that we hedge
against? According to the Modern
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Portfolio theory there are two types of
risks. Systemic risk basically refers to
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the market risks you cannot diversify
away. These types of risks, which include
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events such as recessions, wars and
interest rates. even portfolio risk
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adjustment is unable to reduce this risk
since many risk events are related to
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black Monday's or Friday's where the
market opens at a much lower level.
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Systemic risk can be hedged or insured
against an event with options. A good
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diversified portfolio needs less options
or insurance to insure against the
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systemic risk. The unsystematic risks, also
known as specific risks, are specific to
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any individual stock. You can diversify
away the unsystematic risks by
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increasing the number of stocks in your
portfolio. Take a look at this graph, it
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displays the component of the stock
returns. These returns are not correlated
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with the movement of the general market.
There's a general perception that risk
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is dangerous,
a negative connotation attached to the
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term risk. As an investor you must
understand risk objectively. Risk is an
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integral part of any investment that you
make which is why you should welcome it.
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Risk is what allows every investor to
gain rewards by taking a chance against
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adverse outcomes. However, according to
Markowitz Portfolio Theory, if an
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investor chooses to diversify his
portfolio he will be able to reduce the
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risk factor from his investment. This is
the reason every investor should see
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risk as an important part of their
investment. While you're deciding on what
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type of assets you should go with it's
important to ensure that the assets you
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choose are unrelated. The unrelated
assets are unlikely to have related
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risks so if you choose the same type of
assets for your portfolio then there's a
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high probability that their price
movements will have a similar pattern.
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The lack of correlation between two
assets will help investors to have
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diversified portfolio hence, reducing the
total risks involved. Hope you enjoyed
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the video if you'd like to learn about
our Algo Trading strategies you can
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subscribe to our members list. Link's in
the description. At SAMT AG we make
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diversified portfolio, which is a great
choice against normal market risk. It
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provides a hedge against wild market
swings such as a drop or 30% or more. We
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hedge portfolios with an out of the
money option, which is way cheaper since
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it's way out of the money, but the
protection it allows against unlikely
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events is extremely useful. You reap
benefits of hedging as long as the
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market is not down. In fact, you will have
over-proportion or a significant
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advantage in your risk-to-value ratio
with our hedging strategy. When the price
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of your portfolio exceeds the strike
price, you start making very healthy
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gains. If you have any questions let us
know in the comments section. I'm Nael
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from SAMT AG and I'll see you soon.
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