STSM112130 - Derivatives: introduction to options: hedging a derivative

The writer or issuer of an equity derivative such as an option, future, warrant etc, is explosed to risk, as they will not generally know whether the holder will exercise the derivative any time within the agreed time period.

Often, 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 for example satisfy or ‘cover’ 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 quantities of the underlying shares during the period of the option, or more frequently;
• offsetting their exposure on the written call option by purchasing a call option from another exchange member.

This practice of minimising risk is called hedging.

See STSM112120 and STSM042090 for information on stamp duty and Stamp Duty Reserve Tax (SDRT) relief that is available to a recognised intermediary when ‘hedging’ a derivative.

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