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 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:
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 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.
Net gain: $4,000 − $600 = $3,400.
This highlights the payoff profile:
If you need additional support with this type of hedging strategy, check out this video:
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.
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:
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.
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 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:
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:
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