A hedging strategy involves protecting a stock position with a long option. The word ‘hedge’ is a common term in the securities industry. Any product or investment used to protect something else is a hedge.
Here’s a quick video introduction to this type of option strategy:
What does an investor maintaining a long stock position fear? The stock price declining, especially if it falls significantly. A long put options contract is an excellent hedge against this risk. Long puts provide the right to sell at a fixed price, regardless of where market prices go. Let’s assume you obtain both of these investments:
Long 100 shares of ABC stock @ $50
Long 1 ABC Jan 50 put @ 6
With a $600 overall premium, the put is costly insurance. However, the contract gives the investor the right to sell ABC stock at $50, no matter how low the stock goes. If the stock falls to $0, the investor could exercise the put and sell ABC stock at $50.
Investors holding these positions together do not want to exercise the put. This concept may seem contradictory to what we learned earlier - investors with long options contracts realize their maximum loss when an option expires. It’s different here, as the put is no longer being used as a “money maker.”
Instead, the long put acts as insurance. Do you ever look forward to using your car insurance? Nope! However, it saves your bank account if you get in an accident. The long put works the same way. The investor hopes ABC’s stock price rises, which results in making more money. The put is only there to “save” the stock position if the market price 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 |
The market price falls below the option’s strike price, and the put goes “in the money” (“put down”). The investor exercises the put and sells the shares at $50 to avoid a larger loss.
The investor initially purchased the shares at $50 and was bullish on those shares (otherwise, why own the shares?). The further ABC’s market price increased, the more money they would make. However, they also held (went long) the put as a hedge. And thankfully, they did! With ABC’s market price declining to $20, the investor would’ve lost $30 per share, or $3,000 overall if they didn’t buy the put. Instead, they exercise the put and sell the shares at $50. Buying and selling the shares at $50 is a “wash,” but they must factor in the cost of the option. Therefore, they realize a $600 overall loss ($6 premium x 100 shares).
This is the investor’s maximum loss. The put will be exercised if the stock price falls below $50, resulting in the stock being sold at $50. No matter how far the market price falls, they still obtain a $50 per share liquidation price.
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 |
The market price rises above the option’s strike price, and the put goes “out of the money” and expires worthless. The shares are valued at $56, netting a $6 per share gain, or a $600 overall profit on the stock. The $600 option premium paid upfront offsets the $600 stock gain.
Although the investor purchased the put as a hedge, they did not need the protection. With the market price rising above the option’s strike price, the put expires worthless.
There are always pros and cons with every investment. The hedge provides protection, but it’s not free. Due to the cost of the premium, the investor needs the shares to rise above $56 to profit. With any hedging strategy, the investor’s stock must make back the hedge cost to break even.
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 |
The market price rises above the option strike price, and the put goes “out of the money” and expires worthless. The shares are valued at $90, netting a $40 per share gain, or a $4,000 overall profit on the stock. The $600 option premium paid upfront reduces the overall gain to $3,400.
This example illustrates the gain potential of this strategy. Although the put hedge cost $600, the investor’s maximum gain is still unlimited. The further the market rises, the more the investor makes. Of course, the premium must be factored in, which reduces the stock’s gain.
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 arguably need a hedge more than investors with long stock positions. If you recall, short sellers borrow securities and sell them immediately. They hope the market price falls, allowing a “repurchase” of the security at a lower price. If the security’s market price rises instead, the repurchase price is higher, resulting in losses. With no ceiling to the market, short sellers are subject to unlimited risk.
Investors that short stock can hedge their positions with long call options contracts, which provide the right to buy the stock at a fixed price. Let’s assume an investor pursues this strategy:
Short 100 shares of ABC stock @ 80
Long 1 ABC Jan 85 call @ $3
The $300 call provides a hedge to the investor. Without the long call, the short stock has unlimited loss potential. By spending $300 on the call, the investor reduces their maximum loss dramatically.
You probably noticed how the strike price ($85) differs from the short stock transaction price ($80). Investors have numerous choices when it comes to option contracts. An $80 call allows the investor to purchase the shares back at $80, but would also have a premium at least $500 higher than an $85 call. This investor is probably trying to save money on the premium by going with a less desirable strike price.
Like the previous hedging strategy, the shares are the essential element of the investment. The investor wants ABC’s market price to fall, allowing them to purchase the shares back at a lower price and potentially profit. The investor must be aware of the short position’s risk, which is why the call was purchased. The call is only exercised if the market price rises above the strike price (“call up”), allowing the investor to buy back the shares at $85 (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 |
The market price falls below the option’s strike price, and the call goes “out of the money” and expires worthless. With ABC’s market price at $50, the investor locks in a $30 per share stock gain, or $3,000 overall. The $300 premium paid upfront reduces the overall gain to $2,700.
This example illustrates the gain potential of this strategy. Although the call hedge cost $300, the investor made a significant return as the market fell. The further the market falls, the more the investor makes. Of course, the premium must be factored in, which reduces the stock 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 |
The market price falls below the option’s strike price, and the call goes “out of the money” and expires worthless. With ABC’s market price at $77, the investor locks in a $3 per share stock gain, or $300 overall. The $300 premium paid upfront offsets the stock gain, and the investor breaks even.
Although the investor purchased the call as a hedge, they did not need the protection. With the market price falling below the option’s strike price, the call expires worthless.
The hedge provided protection (although it was not needed), but wasn’t free. Due to the cost of the premium, the investor needs the shares to fall below $77 to profit. With any hedging strategy, the investor’s stock must make back the hedge cost to break even.
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 |
The market price rises above the option’s strike price, and the call goes “in the money” (“call up”). The investor exercises the call and buys back the shares at $85 to avoid a larger loss.
The investor initially sold short the shares at $80 and was bearish on those shares (otherwise, why short the shares?). The further ABC’s market price fell, the more money they would make. However, they also held (went long) the call as a hedge. And thankfully, they did! With ABC’s market price rising to $100, the investor would’ve lost $20 per share, or $2,000 overall if they didn’t buy the call. Instead, they exercise the call and buy back the shares at $85. Selling short at $80 and buying back at $85 results in a $5 per share loss, or $500 overall. Additionally, the cost of the call must be factored in. The $300 premium paid upfront increases the overall loss to $800.
This is the investor’s maximum loss. The call will be exercised if the stock price rises above $85, resulting in the stock being bought back at $85. No matter how far the market price increases, they still obtain an $85 per share buyback price.
If you need additional support with this type of hedging strategy, check out this video:
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