What is Foolsaurus?

It's a glossary of investing terms edited and maintained by our analysts, writers and YOU, our Foolish community. Get Started Now!


Can I Hedge a Call-Option With a Put-Option?

Original post by Rocco Pendola of Demand Media

Buying a call option reflects bullish sentiment just like purchasing shares of stock. When you buy a call, your position has the best chance at a profit if the option's underlying stock rises in value. The main difference between the two strategies is the capital required to execute the trade; buying an option contract always requires less money than buying 100 shares of the underlying stock. Just as you can hedge a long stock position with puts, you can do the same to a long call.

Contents

Purpose

When you buy a call option, you are generally optimistic about the option's underlying stock rising in value leading up to the option contract's expiration date. If you choose to buy a put -- an option that profits if the underlying stock decreases in value -- you're essentially buying insurance against your long call position. This is a hedge. A hedge is just another way to refer to mitigating risk.

Execution

Assume you purchased a call contract with a strike price of $40 at a premium of $3.00. Your capital outlay in this scenario is $300. To hedge that position with a put option, you could purchase a put with a strike price of $45, for example. If the premium of that option cost $2.50, you would have spent $250 (option premiums use a multiplier of 100 to determine their real cost) to hedge your long call position.

Example

If the $40 strike call you purchased dropped to $2.00 shortly after you purchased it due to a drop in the value of the underlying stock, you would have an on-paper loss of $100. The $45 strike put you purchased as insurance, however, would have, most likely, risen in value. You could sell to close the put position and collect profits from the now higher-priced premium. This allows you to profit while you wait out your long call position or offset any losses incurred if you chose to close it out.

Considerations

Many factors other than movement determine the value of option premiums. These factors include how close the option is to expiration as well as volatility in the underlying stock. You must take these and other factors into consideration not only when purchasing a call and hedging it with a put, but when deciding what strike prices and expiration months to select for each position.


                   

Resources

References

About the Author

As a writer since 2002, Rocco Pendola has published numerous academic and popular articles in addition to working as a freelance grant writer and researcher. His work has appeared on SFGate and Planetizen and in the journals "Environment & Behavior" and "Health and Place." Pendola has a Bachelor of Arts in urban studies from San Francisco State University.


Advertisement