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 the stock price falling (especially a large decline). A long put options contract is a common hedge against that risk.
A long put gives you the right to sell the stock at a fixed price (the strike price), no matter how low the market price goes. Suppose 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 “insurance cost.” In return, the contract gives you the right to sell ABC at $50 even if the market collapses. If ABC fell to $0, you could still exercise the put and sell at $50.
When you hold long stock plus a long put, you generally don’t want to exercise the put. That can feel backwards at first, because with a standalone long option, the maximum loss happens when the option expires worthless. Here, the put isn’t being used primarily to generate profit - it’s being used to limit the downside on the stock.
Think of the put like insurance: you hope you never need it, but it’s there to protect you if the stock drops below $50.
Let’s go through a few examples to see how the hedge changes the outcome.
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 stock loss.
This $600 is the investor’s maximum loss in this hedged position. Once 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 exactly offset by the $600 premium, so the position breaks even.
This shows the trade-off in hedging: the protection isn’t free. The stock has to rise enough to cover the hedge cost before you see a net profit. In this case, the breakeven stock price is $56.
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 upside of the strategy: even after paying for the hedge, the maximum gain is still unlimited because the stock can keep rising. The put premium simply reduces the overall profit.
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. If you recall, short sellers borrow shares 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, the buyback cost increases and the short seller loses money. Because there’s no limit to how high a stock can rise, short stock has unlimited risk.
A common hedge for short stock is a long call options contract, which gives the right to buy the stock at a fixed price. Suppose 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 investor’s profit potential, but it also caps the worst-case loss.
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 also cost more (a higher premium) than an $85 call. Choosing the $85 strike is a way to lower the hedge cost, while still limiting the most extreme losses.
In this strategy, the short stock position is still the main driver of profit or loss. The investor wants ABC’s market price to fall. The call is there as protection and is typically exercised only if the market price rises above the strike price (“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.
Net gain: $3,000 − $300 = $2,700.
This example shows the profit potential when the market falls. 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, that maximum gain 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 stock gain is offset by the premium, so the investor breaks even.
As with any hedge, the protection has a cost. Here, the stock must fall enough to “earn back” the $3 premium before the overall position becomes 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, avoiding a larger loss.
Total loss: $500 + $300 = $800.
This is the investor’s maximum loss in this hedged position. Once 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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