IOSR Journal of Business and Management (IOSR-JBM) e-ISSN: 2278-487X, p-ISSN: 2319-7668. Volume 17, Issue 9.Ver. I (Sep. 2015), PP 06-11 www.iosrjournals.org DOI: 10.9790/487X-17910611 www.iosrjournals.org 6 | Page “Hedging With a Stock Option” Afzal Ahmad Assistant Professor of Accounting International Islamic University Chittagong Chittagong Abstract: The aim of this paper is to provide a discussion of the use of stock options in risk management and how they can be used for hedging purposes. This aim is achieved by reviewing the literature and analysing practical hedging examples in the context of an investment company. The results of the discussion show that stock options can be employed by companies as a protection against the downside risk when volatility in the market is high. They can also be used during the periods of low volatility to achieve a specific expected payoff within a band of stock prices. The case study reviewed the strategies that involved naked put and calls as well as more complex hedging procedures, namely the butterfly strategy and the bear spread strategy. By purchasing a put option or selling a call option, the company anticipates a decrease in stock prices as in this case there would be a positive payoff. However, when higher prices are anticipated, the company is interested in purchasing a call option or selling a put option. The butterfly strategy allows the firm to cut potential losses and profits to a specific range whereas the bear spread protects against an increase in volatility. The latter strategy implies entering positions in options with different strike prices. I. Introduction: The aim of this study is to assess the use of stock options contracts in risk management. Stock options are derivative instruments that provide a right to the holder to purchase the stock of the company, which is used as the underlying asset (Kolb and Overdahl, 2010). Moreover, if the company is involved in stock trading and purchases of shares of other companies, stock options can be used as hedging instruments to protect against the downside risk (Lien and Tse, 2001). While stock options give the right to buy or sell stocks at a particular price, there is no obligation to do this. The company may choose not to exercise the option, and this flexibility is one of the advantages of this type of derivative instruments compared to alternatives such as futures and forward contracts (Mitra, 2013). Companies that are involved in purchases of stocks are faced with the market risk. For this reason, it is important to investigate how the stock options contracts are used to mitigate and manage such risks. The next section of the paper provides a brief literature review on the use of options and the case study that follows provides a discussion of the practical hedge strategies employed by investment companies. II. Literature Review: Companies can use options for hedging purposes and this is one part of risk management (Norden, 2001). Options are generally divided into call options and put options. When used for hedging purposes, call options provide the right to purchase a particular amount of stocks or enter a long position. The price and a period of time of such purchase are predetermined (Tompkins, 2002). However, depending on whether a European or American option is used, there is more or less flexibility in regards to the exercise date. For instance, the company is allowed to exercise a European option exactly on the date of maturity (Sasidharan, 2009). In contrast to this, if an American option is used, the company has the right to exercise it earlier before the date of maturity (Norden, 2001). An option holder does not have an obligation to buy the security and this is the major difference of options from futures and forward contracts. Still, an option holder pays the option premium and therefore needs to evaluate whether the benefits of an option hedge are worth this premium (Madura, 2011). The premium is paid regardless whether the option is exercised or not. Put options provide the buyers of the option with the right to sell a particular amount of securities at a predetermined price and within a predetermined period (Wang et al., 2014). Similarly to the call option the put option contract is the right but not the obligation for the holder of the option. Normally the buyer of the call option expects an increase of the price of the underlying security in future. In this case if the exercise price of an option is lower than the market price, the option is considered in-the-money and the option holder has an opportunity to buy the security at the price that is below market price (Smith, 2008). On the other hand, the holder of the put option expects a decrease of the security price in future. Thus he seeks an opportunity to sell the security at a price that is higher than market price (Roberts, 2006). However, if the current strike price of the option is lower than the market price, the put option is considered out-of-the-money (Allen, 2012). One of the disadvantages of options hedging is the fact that the cost of hedging is not known at the time of purchase of the options. It becomes known only when the payables are due (Lai and Lim, 2009). Therefore option holders need to assess what would be the cost of hedging under different circumstances. The cost of