Let's compare hedging with forwards versus hedging with options.

Assume you are long an asset with a spot price of 100 and are looking to hedge this position. The three month forward price is 101 and a three month put with a 101 strike is quoted at a premium of 3. We're asked to calculate and chart the profit and loss or P&L profile for both hedges at expiry in three months for a price range from 90 to 110. In Excel I see the same text that we just saw with some of the numbers that have been pulled out. And then underneath I've got two tables. I've got my P&L for the Ford Hedge, and I've got my P&L for the put hedge. And down the left hand side we've got the asset price at a range of prices.

A quick reminder of the scenario at the moment, the current spot price for an asset is 100 and I want to lock in a sale price of 101 using a forward. So let's imagine we come to three months time and I want to sell and I want to sell for 90. Oh dear, that's really low. I subtract out the price that I bought at 100. Oh no, I'm going to look onto that. We may, we would've made a loss of 10, but hang on. We had a forward and the forward meant that we could guarantee ourselves a sale price of 101, and I'll lock onto that.

Subtract away the asset price currently of 90. Ooh. So we beat the current price of by 11, the combined, I can sum the asset P&L and the Ford P&L to give myself a combined profit of 1. Effectively I bought 100 and I sold for 101. That happens at all of the prices here. So I can select all of the cells below, or I can grab that fill handle and pull it down.

And that gives us a guaranteed output of one profit.

What about the put hedge? How does that change? Well, my asset P&L initially is exactly the same. If I buy for 100, sell for 90, oh dear, make a loss of 10.

The put initially starts the same. Initially I say I can sell at 101. Great lock onto that. Subtract away the asset price 90. Oh, fantastic. There's a nice little profit to be made there, but hang on, we have to pay a premium to buy a put hedge. Just to notice here it says we buy the put to hedge. We are buying the ability to sell at at some point in the future, and when we buy that, it costs us three. So unfortunately I have to pay a kind of fixed cost of three. I'm going to lock onto that. So my profit that was initially 11, 101 minus the 90, I subtract 3 to give me A put P&L of 8. So my combined gives me a figure of minus 2. Now, initially, that's correct. I'm going to copy all of those numbers down, but I notice I've done something slightly wrong in my put P&L. When we get down to a price of 102, I wouldn't want to make that deal that's currently happening here. I wouldn't want to buy it for 102 and sell it for 101. I'd like to avoid that if I can. And that's the benefits of a put option. It's the option to exercise the puts or in this case, the option to let it lapse. At the moment. This option's making me a loss buy for 102, self 101. I would let it lapse instead. So I'm going to update the formula by putting a max function in here. I want to change this part here so it can't make a loss, so I'll put comma zero. And now this section here can only give me a positive number. I'm going to make sure I do that up at the top cell. Don't do it at the bottom. So max comma zero, and then I'll copy that all the way down to the cells below. And let's see what happens at a price of 102 at a price of 102 C10 minus B27. C10 is 101 minus 27. Oh dear. That would give me a loss. I let that lapse. It's replaced with a zero and instead my only cost is C11. My only cost is the premium.

So I see now a big difference between the forward hedge and the put hedge.

My forward hedge gives me a fixed outcome, in this case of one my puts hedge at low asset prices I have a fixed small loss of negative two. Mostly from that put premium.

But when the asset prices go up very good, we let the put option expire and our outcome could be very attractive indeed.

And we've got two payoff graphs to try and help explain this in the hedge with a forward, I can see this gray line here. I have a fixed outcome at all prices. My forward P&L profits, it's offsets by my asset P&L loss giving me that fixed outcome.

But in the hedge with a put option slightly different, my gray combined outcome starts negative from the premium that we have to pay. But when the asset prices get higher, we forget about the put option. We let that lapse and we start to enjoy some of the profits from the asset P&L. The asset P&L is shown in blue. Unfortunately, we're slightly below that because we've had to pay that premium of 3.

But this gives us the major difference between a forward and an option A forward gives us a fixed outcome. An option gives us a limited downside, that fixed low combined output there, but gives us upside potential.