Written options as a hedging instrument
Why a written option cannot be used as a hedging instrument?
The objective of hedging is to minimise the risk and/or to protect the unrealised profits. A hedging instrument should typically restrict the exposure to loses while at the same time provide scope for unlimited profits. The bought option exactly achieves these two requirements. A bought call option has a maximum risk to the extent of the premium paid while leaves open a potential to make unlimited gains. A written call option on the other hand pegs the maximum profit which is the premium received, leaving open a potential to make unrestricted losses. The same is the case for written put option as well. Hence, a written option which increases the risk exposure cannot be designated as a hedging instrument.