Hedge Strategies

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 loss zones. Long hedge profit and
loss zones.[/caption]

In this case, you sold short 100 shares of stock at $43, and hedged that position with a May 40 call bought at 2.

The cost of hedging your short position reduces potential profits by $200, but protects you against potentially greater losses without requiring that you close the position. The risk is eliminated until the call expires. At that point, there are three choices:

  1. Close the short position to eliminate risk.
  2. Replace the call with another, later-expiring one.
  3. Do nothing, since perception of the risk attributes might have changed.


Trimming 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.


Allowing 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.

In this example, if the underlying stock's market value increases, then profit potential is limited to the offsetting price gap between the stock's market value and the call's premium value. If the stock's market value falls, the short stock position will be profitable, with profits reduced by two points for the call premium you paid.

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
430+ 100+ 100
42+ 1000+ 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 Coverage

One 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 loss zones. Reverse hedge profit and
loss zones.[/caption]

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 Tip

The 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.

Table below summarizes this position's value as of expiration at various stock prices.

Profits/Losses from Reverse Hedge Example

44- 100+ 400+ 300
430+ 200+ 200
42+ 1000+ 100
41+ 200- 2000
40+ 300- 400- 100
39+ 400- 4000
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 Positions

Hedging 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.


Three 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.

This particular situation would be difficult to create all at once with a net credit, because the lower striking price calls would probably cost more than the higher-priced short position call. However, the variable hedge may be created in stages as a response to changing conditions. You can limit the risk exposure when short positions exceed long, by combining LEAPS and shorter-term options. A long LEAPS offset by soon-to-expire short position calls, for example, provides a return of premium and limited time at risk.

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. 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
660- 100- 100
65- 3000- 300
64- 300+ 100- 200
63- 300+ 200- 100
62- 300+ 3000
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
650- 300-300
64+500- 300+200
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).
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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