Mastering Derivatives: Do Puts Hedge?

Many consider options as a hedging instrument. Now, hedging is a process that would be meaningful for companies. This is because companies prefer to manage their financial risk and concentrate more on running their core business. Should derivative traders also use options as a hedge? This week, we discuss the arguments you should consider before using puts as a hedging instrument.

Hedging cost

A hedge is a process that is meant to reduce the downside risk in an investment portfolio. This could be done with specific objective of managing the risk associated with a macro-economic event or to manage the downside risk at the end of a time horizon for a life goal. Can short-dated exchange-traded options be used as a hedging instrument?

Suppose you are long on stocks or have invested in mutual funds. You are anxious to protect the unrealized gains in your portfolio as you are nearing the end of the time horizon for a life goal. You could buy Nifty Index puts to lock-in to the unrealized gains on your portfolio. But that could work only if the gains on the puts offset the loss in the portfolio value. For that to happen, you must buy optimal number of puts on the Nifty Index. This requires you to determine the optimal hedge ratio, taking into consideration the correlation between the Nifty Index and your portfolio value over time. Even if you were to do that, the premise is that the relationship between the Nifty Index and your portfolio will remain the same during the hedging horizon as it was in the past.

You may argue that puts can be used to “hedge” individual positions. Technically, hedge is applied at a portfolio level, not for individual positions. But setting aside that argument, consider a long futures position that you want to “hedge” with puts on the same underlying. Your “hedge” will work only if the loss from long futures is equal to the gains from the long puts. But that may be difficult, unless the put becomes deep in-the-money (ITM). Why? When the put becomes ITM, the intrinsic value moves one-to-one with the underlying. And that movement must be greater than the loss due to time decay. A deep ITM put will mean that the underlying must fall sharply. And if that is what you expect, why hold the long futures position at all, given that it is also a short-dated contract?

Optional Reading

Buying puts to “hedge” long futures position appears to be more an emotional decision than a technical argument; you may feel less anxious of a sharp potential downside in the futures position. But long put comes at a cost. The best case scenario would be lower gains on your long futures position. The worst-case scenario could be that the long futures position has losses, and the puts expire worthless. That means your total loss will be greater because of the “hedging” cost.

(The author offers training programmes for individuals to manage their personal investments)

Published on February 15, 2026