Whenever options are bought or sold as part of a strategy to protect another open position, the combination of positions represents a hedge.
A long hedge protects against price increases. A short hedge protects against price decreases.
An example of a hedge, with defined profit and loss zones, is shown in Figure below.
[caption id="attachment_12571" align="alignleft" width="304"] Long hedge profit and
In this case, you sold short 100 shares of stock at $43, and hedged that position with a May 40 call bought at 2.
- Close the short position to eliminate risk.
- Replace the call with another, later-expiring one.
- Do nothing, since perception of the risk attributes might have changed.
ExampleTrimming the Hedge: You are short on 100 shares of stock. This puts you at risk in the event the market value of that stock were to rise. You buy one call on that stock, which hedges your short stock position.
ExampleAllowing the Hedge to Grow: You own 100 shares of stock and, due to recent negative news, you are concerned that the market value could drop. You do not want to sell the shares, however. To hedge against the risk of lost market value, you have two choices: Buy one put or sell one call. Both positions hedge the 100 shares. The put provides unlimited protection because it would increase in value for each in-the-money point lost in the stock's value. The call provides limited downside protection, only to the extent of the points received in premium.
Table below summarizes this hedged position's overall value at various stock price levels.
Profits/Losses from the Long Hedge Example
|44||- 100||+ 200||+ 100|
|43||0||+ 100||+ 100|
|42||+ 100||0||+ 100|
|41||+ 200||- 100||+ 100|
|40||+ 300||- 200||+ 100|
|39||+ 400||- 200||+ 200|
|38||+ 500||- 200||+ 300|
|37||+ 600||- 200||+ 400|
|36||+ 700||- 200||+ 500|
|35||+ 800||- 200||+ 600|
Hedging beyond CoverageOne of the disadvantages to the hedge is that potential profits may be limited. A solution is to modify the hedge to increase profit potential, while still minimizing the risk of loss.
A reverse hedge involves providing more protection than needed to cover another position. For example, if you are short on 100 shares of stock, you need to purchase only one call to hedge the position. In a reverse hedge strategy, you buy more than one call, providing protection for the short position and potential for additional profits that would outpace stock losses 2 to 1, for example; with three calls, the ratio would be 3 to 1. Three calls applied against 200 shares of stock would produce a ratio of 3 to 2. The ratio can also be negative. For example, using two calls against 300 shares of stock provides a 2-to-3 negative reverse; you mitigate the potential loss, but you don't offset the entire potential loss.
An expanded example of a reverse hedge with defined profit and loss zones is shown in Figure below. In this example, you sold short 100 shares of stock at $43 per share, and the value now has declined to $39. To protect the profit in the short position and to insure against losses in the event the price rises, you bought two May 40 calls at 2.
[caption id="attachment_12572" align="aligncenter" width="300"] Reverse hedge profit and
This reverse hedge solves the problem of risk in the short stock position, while also providing the potential for additional gain in the calls. In order for this profit to materialize, the stock's value would have to increase enough points to offset your cost in buying the calls. This hedge creates two advantages. First, it protects the short position in the event of unwanted price increase in the stock. Second, the 2-to-1 ratio of calls to stock means that if the price were to increase in the stock, the calls would become profitable.
Smart Investor TipThe reverse hedge protects an exposed position while adding the potential for additional profits (or losses). This makes the hedge more than a form of insurance.
Profits/Losses from Reverse Hedge Example
|44||- 100||+ 400||+ 300|
|43||0||+ 200||+ 200|
|42||+ 100||0||+ 100|
|41||+ 200||- 200||0|
|40||+ 300||- 400||- 100|
|39||+ 400||- 400||0|
|38||+ 500||- 400||+ 100|
|37||+ 600||- 400||+ 200|
|36||+ 700||- 400||+ 300|
|35||+ 800||- 400||+ 400|
The reverse hedge works to protect paper profits in long positions as well. For example, you may own 100 shares of stock which has risen in value. To protect against a possible decline in market price, you may buy two puts, a reverse hedge that would produce 2-to-1 profits in the puts over decline in the stock's value. You may also sell two calls for the same reason. One would be covered while the other would be uncovered. Or, looking at this another way, the hedged position would be one-half covered overall. If the stock's market value were to fall, the calls would lose value, providing downside protection to the extent of the total premium received. However, if the stock were to rise, profits in the stock would be reduced by losses in the calls. As with short positions, you can use options for partial hedging. For example, if you own 500 shares of appreciated stock, selling four calls (or buying four puts) provides you with a 4-to-5 ratio protecting against lost market value. You can also view this as having 400 shares hedged and another 100 shares without a hedge.
Hedging Option PositionsHedging can protect a long or short position in an underlying stock, or it can reduce or eliminate risks in other option positions. Hedging is achieved with various forms of spreads and combinations. By varying the number of options on one side or the other, you create a variable hedge, which is a hedge involving both long and short positions. However, one side will contain a greater number of options than the other.
ExampleThree to One -- Nice Odds: You buy three May 40 calls and sell one May 55 call. This variable hedge creates the potential for profits while completely eliminating the risk of selling an uncovered call. If the underlying stock's market value were to increase above the level of $55 per share, your three long positions would increase in value by three points for every point in the short position. If the stock's market value were to decrease, the short position would lose value and could be closed at a profit.
Long and short variable hedge strategies, with defined profit and loss zones, are shown in Figure below. In the long variable hedge example, you buy three June 65 calls for 1, paying $300; and you sell one June 60 call for 5. Net proceeds are $200. This long variable hedge strategy achieves maximum profits if the underlying stock's market value rises. Above the striking price of 65, long call values would increase three points for every point increase in the underlying stock. If the stock's market value decreases, all of the calls lose value and the net $200 proceeds will be all profit. The short June 60 call could also be closed at a net gain.
[caption id="attachment_12573" align="aligncenter" width="384"] Variable hedge profit and loss zones.[/caption]
Table below summarizes this position's value as of expiration at various stock price levels. The problem in this strategy is that the short positions expire later than the long positions; in most circumstances, this is the most likely way to create a credit in a variable hedge. So you need to experience price movement that creates an acceptable profit before expiration of the long position options, or be prepared to close out the short positions once the long positions expire, to avoid exposure to the risk of exercise.
Profits/Losses from the Long Variable Hedge Example
|69||+ 900||- 400||+ 500|
|68||+ 600||- 300||+ 300|
|67||+ 300||- 200||+ 100|
|66||0||- 100||- 100|
|65||- 300||0||- 300|
|64||- 300||+ 100||- 200|
|63||- 300||+ 200||- 100|
|62||- 300||+ 300||0|
|61||- 300||+ 400||+ 100|
|60||- 300||+ 500||+ 200|
|59||- 300||+ 500||+ 200|
|58||- 300||+ 500||+ 200|
Profits/Losses from the Short Variable Hedge Example
|69||- 2,000||+ 400||- 1,600|
|68||- 1,500||+ 300||- 1,200|
|67||- 1,000||+ 200||-800|
|63||+ 1,000||- 300||+700|
|62||+ 1,500||- 300||+ 1,200|
|61||+ 2,000||- 300||+ 1,700|
|60||+ 2,500||- 300||+ 2,200|
|59||+ 2,500||- 300||+ 2,200|
|58||+ 2,500||- 300||+ 2,200|
The previously discussed Figure (Variable hedge profit and loss zones) also shows an increasing loss zone and limited profit zone in the example of a short hedge. In that case, you sold five June 60 calls for 5, receiving $2,500; and you bought three June 65 calls for 1, paying $300; net proceeds were $2,200. This short variable hedge strategy is a more aggressive variation than the long example, with more proceeds up front and a corresponding higher risk level overall. When the offsetting long and short call positions are eliminated, two short calls remain uncovered. A decline in the value of the underlying stock would create a profit. However, an increase in the stock's market value creates an increasing level of loss. Beyond striking price, the loss is two points for every point of movement in the stock's price. Outcomes for this short hedge at various price levels of the stock are summarized in Table above (Profits/Losses from the Short Variable Hedge Example).