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:
If you’re holding a long stock position, the main risk is that the stock price declines (especially a large decline). A long put options contract is a common hedge against that risk because it gives you 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 total ($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 ABC fell to $0, the investor could still exercise the put and sell at $50.
When you use a put as a hedge, you typically don’t want to exercise it. That can feel backwards if you’re thinking of options mainly as profit tools. Here, the put isn’t meant to be a “money maker.” It’s there to limit losses on the stock.
A helpful way to think about it: you don’t buy car insurance hoping to use it. You buy it so that if something goes wrong, the damage is limited. The long put plays the same role. The investor hopes ABC rises (so the stock makes money), and the put is there only to protect the position if ABC 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.
This $600 is the investor’s maximum loss in this hedged position. If the stock falls below $50, the investor can still sell at $50, so further declines don’t increase the loss.
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.
This shows the tradeoff in hedging: the protection isn’t free. The stock has to rise enough to cover the premium before the overall position shows 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.
This example highlights the upside of the strategy: the investor’s maximum gain is still unlimited (the stock can keep rising). The put premium reduces the profit, but it doesn’t cap it.
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 investors with long stock positions. If you recall, short sellers borrow securities and sell them immediately. They profit if the market price falls, because they can buy the shares back later at a lower price. If the market price rises instead, buying the shares back costs more, creating losses. Since there’s no ceiling on how high a stock can rise, short sellers face unlimited risk.
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. 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 total ($3 × 100 shares). Without the call, the short stock has unlimited loss potential. By paying $300 for the call, the investor limits the worst-case outcome.
You may notice the strike price ($85) is different from the short sale price ($80). Investors can choose among many strikes. An $80 call would let the investor buy back at $80, but it would likely cost more than the $85 call. In this example, the investor is reducing the premium by choosing a higher (less protective) strike.
As with the long-stock hedge, the stock position is the core investment. The investor wants ABC to fall so they can buy back at a lower price and profit. The call is there for protection. If ABC rises above $85, the call becomes valuable and can be exercised (“call up”), allowing the investor to buy back at $85 in the worst-case scenario.
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.
This example shows the profit potential: the further the stock falls, the more the short position gains (though the premium always reduces the net result). 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.
Again, the hedge provides protection, but it isn’t free. The stock has to fall enough to cover the premium before the overall position shows 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 $800 is the investor’s maximum loss in this hedged position. If the stock rises above $85, the investor can still buy back at $85, so further price increases don’t increase the loss.
If you need additional support with this type of hedging strategy, check out this video:
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