Hedging strategies
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:
Long stock with a long put hedge
A long stock investor’s main concern is the stock price falling, especially a large decline. A long put options contract is a common hedge against that risk because it gives the right to sell at a fixed price, no matter how low the market price goes.
Assume you establish both positions:
Long 100 shares of ABC stock @ $50
Long 1 ABC Jan 50 put @ 6
The put costs $600 (6 × 100 shares). That premium is the cost of the insurance. In return, the investor has the right to sell ABC at $50 even if the stock drops far below $50. If the stock fell to $0, the investor could still exercise the put and sell at $50.
When you hold long stock and a long put together, you hope you never need to exercise the put. That can feel backwards if you’re thinking of the option as a standalone profit opportunity. Here, the put isn’t primarily a “money maker” - it’s protection.
A helpful analogy is 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 long put plays the same role. The investor wants the stock to rise; the put is there to limit losses if the stock falls below $50.
Let’s work through a few examples.
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.
Here’s the logic:
- Without the put, the stock would be down $30 per share ($50 − $20), or $3,000.
- With the put, the investor can still sell at $50.
- Buying at $50 and selling at $50 is a wash on the stock, but the investor still paid the $600 premium.
So the total loss is the premium: $600.
This $600 is the investor’s maximum loss in this hedged position. If the stock falls below $50, the investor can always sell at $50 by exercising the put, 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 stock is up $6 per share ($56 − $50) = $600 gain.
- The put premium was $600.
The stock gain is exactly offset by the premium, so the investor breaks even.
This shows the tradeoff in hedging: the protection isn’t free. With a $6 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 stock is up $40 per share ($90 − $50) = $4,000 gain.
- Subtract the $600 premium.
Net gain: $4,000 − $600 = $3,400.
This highlights the payoff profile:
- Maximum loss is limited (to the premium, in this example).
- Maximum gain is still unlimited because the stock can keep rising.
If you need additional support with this type of hedging strategy, check out this video:
Short stock with a long call hedge
Now let’s look at the other common stock-and-option hedge.
Investors with short stock positions often need a hedge even more than long stock investors. A short seller borrows shares and sells them immediately, hoping the market price falls. Later, they must repurchase the shares to return them.
- If the market price falls, the repurchase is cheaper and the short seller can profit.
- If the market price rises, the repurchase is more expensive and the short seller loses money.
Because there’s no upper limit to how high a stock can rise, short selling has unlimited risk. (You can learn more in the short sales chapter.)
A short stock position can be hedged with a long call options contract, which gives the right to buy the stock at a fixed price. Assume an investor sets up 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 has unlimited loss potential. By paying $300 for the call, the investor caps the worst-case outcome.
You’ll notice the call strike price ($85) is higher than the short sale price ($80). Investors can choose different strikes:
- An $80 call would let the investor buy back at $80, but it would typically cost more.
- An $85 call is cheaper, but it allows a larger loss before the hedge fully kicks in.
In this hedged position, the short stock is still the main bet: the investor wants ABC’s market price to fall. The call is there for protection. If the market price rises above $85, the call becomes in the money (“call up”), and exercising it allows the investor to buy back shares at $85 (the worst-case buyback price).
Let’s work through a few examples.
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 short stock gains $30 per share ($80 − $50) = $3,000.
- Subtract the $300 premium.
Net gain: $3,000 − $300 = $2,700.
The further the stock falls, the more the short position gains (up to the maximum gain if the stock goes to $0). In this example, if ABC fell to $0, the stock gain would be $8,000, and the net gain after the $300 premium would be $7,700.
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 short stock gains $3 per share ($80 − $77) = $300.
- The call premium is $300.
The premium offsets the stock gain, so the investor breaks even.
This is the same tradeoff you saw with the long-stock hedge: the hedge costs money. Here, the stock must fall below $77 for the overall position to be profitable.
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.
Here’s the logic:
- Without the call, buying back at $100 would create a $20 per share loss ($100 − $80) = $2,000.
- With the call, the investor buys back at $85.
- Selling short at $80 and buying back at $85 creates a $5 per share loss = $500.
- Add the $300 premium.
Total loss: $500 + $300 = $800.
This $800 is the investor’s maximum loss in this hedged position. If the stock rises above $85, the investor can always buy back at $85 by exercising the call, no matter how high the market price goes.
If you need additional support with this type of hedging strategy, check out this video: