Hedging With Options

If you have been getting stock options explained to you via this stock options guide, it should be pretty clear by now there are many ways to use options that do not involve increased risk, that in fact serve to reduce overall risk in our portfolio. In a nutshell writing calls and puts usually gives us this ability. In the largest sense, writing options is about hedging, taking the safer side of a transaction in which the person on the other side of the trade is achieving leverage.

As leverage (such as one can achieve by buying calls and puts) is all about making huge gains on a usually smallish amount of money, hedging (e.g. with options) is about achieving rather small percentage gains on (usually) existing positions that are often quite large. If my aim is to explain stock options basics then I must cover both sides of options transactions- the buy (long) side and the sell (short) side.

Hedging can be a better strategy than simply holding a position and being fully exposed to a possible price downturn. Farmers use the commodity markets to ensure that they get a certain price for at least a portion of their crop, guarding against possible lower prices for a not-yet-harvested crop.

We can do this with stock options by selling someone a right to purchase something we own at a higher price, with the stipulation being that if the market never takes the price that high, by a certain date, that we keep the money that we got for selling that right in the first place.

With stock options you can create an income by selling calls with a strike price higher than the current price of the stock, against shares that are already in your portfolio. If you’re not ready to sell your stock in a given company at its current price, but would be happy to sell it at a higher level, simply write a call for each 100 shares of stock you own, with a strike price at which you would be satisfied to sell. In this way, if your shares continued to rise and the price is higher than the strike at expiration, your call will be exercised and you will deliver the shares at the strike price. If your shares are not priced above the strike price at expiration, the calls that you have written will expire worthless and you will simply keep the premium amount that you received for writing them (as well as your shares, of course). Many, many savvy investors with large portfolios make nice rates of return in this way, against stock that they are still bullish on, but could be persuaded to sell at higher levels. The downside of this strategy is that as you are obligated to sell at the strike price, assuming the call is in the money at expiration, you would miss out on any further rise in the price of the stock beyond the strike price.

The concept is exactly the same with puts incidentally, except reversed: for stock that you are short and still bearish on, but interested in hedging, you could write a put contract for every 100 shares that you are short and would like to include in the position, puts with a strike price at which you’d be satisfied in covering your short shares. If at expiration the stock is above the strike price the puts will expire worthless and you will keep the premium, and if this stock price is below the strike price, you’ll simply be forced to cover the applicable shares at the strike price.