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 for this risk because it gives you the right to sell the stock at a fixed price (the strike 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 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 options as profit tools. Here, the put isn’t primarily a “money maker” - it’s protection.
A useful way to think about it 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. The most financially prudent action is to exercise the put and sell the shares at $50, avoiding a much larger stock loss.
That $600 is the investor’s maximum loss in this hedged position. If the stock falls below $50, the investor can still sell 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 $600 stock gain is offset by the $600 premium, so the position breaks even.
This shows the tradeoff in hedging: the protection isn’t free. The stock must rise enough to cover the premium before the investor has a net profit. In this example, the breakeven stock price is $56 ($50 + $6).
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 example highlights the payoff shape of the strategy: the put limits downside risk, but the upside remains unlimited (minus the premium).
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. When you short a stock, you borrow shares and sell them immediately. You profit if the market price falls, because you can buy the shares back later at a lower price. If the market price rises instead, you must repurchase at a higher price, creating losses. Because there’s no upper limit to a stock’s price, short stock has unlimited risk.
A common hedge for short stock is a long call options contract, which gives you the right to buy the stock at a fixed price (the strike 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). That premium reduces the short position’s risk by setting a worst-case repurchase price: if the stock rises above $85, the investor can exercise the call and buy shares at $85.
You may notice the strike price ($85) is higher than the short sale price ($80). Investors can choose among many strikes. An $80 call would provide tighter protection (buy back at $80), but it would typically cost more than an $85 call. In this example, the investor is likely reducing premium cost by choosing a higher strike.
As with the long stock hedge, the stock position is the core investment idea. The investor wants ABC’s market price to fall. The call is there as protection and is only exercised if the market price rises above the strike 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.
This example shows the upside of the strategy: the further the stock falls, the more the short stock profits (though the call premium reduces the net gain). 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 $300 stock gain is offset by the $300 premium, so the position breaks even.
This is the same hedging tradeoff as before: the protection costs money. Here, the stock must fall below $77 ($80 − $3) for the investor to have a net 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. The most financially prudent action is to exercise the call and buy back the shares at $85, preventing an even larger loss.
Total loss = $500 + $300 = $800.
That $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, 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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