A hedging strategy protects a stock position by adding a long option. In the securities industry, a hedge is anything you use to reduce risk in another position.
Here’s a quick video introduction to this type of option strategy:
A key risk for an investor with a long stock position is that the stock price declines, especially if it drops sharply. A long put options contract is a common hedge against this risk.
A long put gives you the right to sell the stock at a fixed price (the strike price), no matter how low the market price goes. Suppose you hold both of these positions:
Long 100 shares of ABC stock @ $50
Long 1 ABC Jan 50 put @ 6
The put costs $600 (a $6 premium × 100 shares). That premium is the cost of the insurance. In return, the contract gives the investor the right to sell ABC at $50 even if the stock falls far below $50. If the stock fell to $0, the investor could still exercise the put and sell at $50.
When you use a put as a hedge, the goal usually isn’t to exercise it. That can feel backwards if you’re thinking about options as profit-seeking trades, where a long option’s maximum loss is the premium paid if it expires worthless.
Here, the put’s job is protection. It’s like car insurance: you don’t buy it because you want to file a claim - you buy it so a bad outcome doesn’t become financially devastating. The investor still wants ABC to rise. The put is there to limit losses if ABC falls below $50.
Let’s go through a few examples to understand this strategy better.
An investor purchases 100 shares of ABC stock at $50 and goes long 1 ABC Jan 50 put at $6. What is the gain or loss if ABC’s market price falls to $20 and the investor takes the most financially prudent action?
Can you figure it out?
Answer = $600 loss
| Action | Result |
|---|---|
| Buy shares | -$5,000 |
| Buy put | -$600 |
| Exercise - sell shares | +$5,000 |
| Total | -$600 |
Because the market price ($20) is below the strike price ($50), the put is in the money (“put down”). The most financially prudent action is to exercise the put and sell the shares at $50, avoiding a much larger loss.
This $600 is the investor’s maximum loss in this hedged position. Once the stock falls below $50, the investor can still liquidate at $50, no matter how far the market price drops.
Let’s try another example:
An investor buys 100 shares of ABC stock at $50 and goes long 1 ABC Jan 50 put at $6. What is the gain or loss if ABC’s market price rises to $56?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Buy shares | -$5,000 |
| Buy put | -$600 |
| Sell value | +$5,600 |
| Total | $0 |
Because the market price ($56) is above the strike price ($50), the put is out of the money and expires worthless. The shares are worth $56, creating a $6 per share gain ($600 total). That $600 stock gain is offset by the $600 premium paid for the put.
Even though the investor didn’t need the protection, the hedge still had a cost. Because of the premium, the stock must rise above $56 for the overall position to show a profit.
One more long stock and long put hedge example:
An investor buys 100 shares of ABC stock at $50 and goes long 1 ABC Jan 50 put at $6. What is the gain or loss if ABC’s market price rises to $90?
Answer = $3,400 gain
| Action | Result |
|---|---|
| Buy shares | -$5,000 |
| Buy put | -$600 |
| Share value | +$9,000 |
| Total | +$3,400 |
Because the market price ($90) is above the strike price ($50), the put is out of the money and expires worthless. The shares are worth $90, creating a $40 per share gain ($4,000 total). Subtract the $600 premium, and the net gain is $3,400.
This shows the trade-off in a protective put:
If you need additional support with this type of hedging strategy, check out this video:
Now that you’ve gone through the long stock & long put hedging strategy, let’s look at the other one.
Investors with short stock positions often need a hedge even more than investors with long stock positions. A short seller borrows securities and sells them immediately. They hope the market price falls so they can repurchase the security at a lower price.
If the market price rises instead, the repurchase price is higher, which creates losses. Because there’s no ceiling on how high a stock can rise, short sellers face unlimited risk. To learn more about this type of transaction, you can skip forward to the short sales chapter.
A common hedge for a short stock position is a long call options contract, which gives the right to buy the stock at a fixed price. Suppose an investor uses this hedge:
Short 100 shares of ABC stock @ 80
Long 1 ABC Jan 85 call @ $3
The call costs $300 ($3 × 100 shares). Without the call, the short stock position has unlimited loss potential. By buying the call, the investor caps the worst-case outcome.
You may notice the strike price ($85) is higher than the short sale price ($80). Investors can choose among many strike prices. An $80 call would let the investor buy back at $80, but it would also cost more (a higher premium) than an $85 call. Choosing the $85 strike is a way to reduce the premium, while still limiting the most extreme losses.
In this strategy, the short stock position is still the main trade. The investor wants ABC to fall so they can buy back at a lower price and profit. The call is there for protection. The call is exercised only if the market price rises above the strike price (“call up”), allowing the investor to buy back at $85 in the worst-case scenario.
Let’s go through a few examples to understand this strategy better:
An investor sells short 100 shares of ABC stock at $80 and goes long 1 ABC Jan 85 call at $3. What is the gain or loss if ABC’s market price falls to $50?
Answer = $2,700 gain
| Action | Result |
|---|---|
| Sell short shares | +8,000 |
| Buy call | -$300 |
| Share buyback cost | -$5,000 |
| Total | +$2,700 |
Because the market price ($50) is below the strike price ($85), the call is out of the money and expires worthless. The investor buys back the shares at $50, locking in a $30 per share gain ($3,000 total). Subtract the $300 premium, and the net gain is $2,700.
This example shows the gain potential of the strategy. The call premium reduces the profit, but the investor still benefits as the stock falls. If the market price fell to $0, the investor would realize their maximum gain ($7,700 in this example).
Let’s try another example:
An investor sells short 100 shares of ABC stock at $80 and goes long 1 ABC Jan 85 call at $3. What is the gain or loss if ABC’s market price falls to $77?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Sell short shares | +8,000 |
| Buy call | -$300 |
| Buy back shares | -$7,700 |
| Total | $0 |
Because the market price ($77) is below the strike price ($85), the call is out of the money and expires worthless. The investor gains $3 per share on the short stock ($300 total), which is exactly offset by the $300 premium.
The hedge wasn’t needed here, but it still had a cost. Because of the premium, the stock must fall below $77 for the overall position to show a profit.
One last short stock & long call hedge example:
An investor sells short 100 shares of ABC stock at $80 and goes long 1 ABC Jan 85 call at $3. What is the gain or loss if ABC’s market price rises to $100 and the investor takes the most financially prudent action?
Answer = $800 loss
| Action | Result |
|---|---|
| Sell short shares | +8,000 |
| Buy call | -$300 |
| Exercise - buy back shares | -$8,500 |
| Total | -$800 |
Because the market price ($100) is above the strike price ($85), the call is in the money (“call up”). The most financially prudent action is to exercise the call and buy back the shares at $85 to avoid a larger loss.
This is the investor’s maximum loss in this hedged position. Once the stock rises above $85, the investor can still buy back at $85, no matter how high the market price goes.
If you need additional support with this type of hedging strategy, check out this video:
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