4.2.2.1. Hedging with Protective Puts and Calls
Suppose you bought 1,000 shares of Apple stock months ago at $400 per share and the stock has since climbed to $500. You want to keep the stock because you like Apple and think its price will continue to rise, but at the same time, you don’t want to risk losing what you have gained. You can hedge your risk on a long position by buying a protective put. In the same way that you buy insurance for protection, you buy a put for protection.
To protect your Apple position, you might buy 10 slightly out-of-the-money puts at $495 for $2 per share. If Apple starts declining, you have purchased the right to sell your shares of Apple at $495 per share, protecting your gains. Though paying the premium for the 10 puts has dampened your potential gains, you still have unlimited growth potential if Apple continues to rise.
To protect short sale gains, you can buy a call. Pretend you have shorted 1,000 shares of Apple at $500 per share and it has since fallen to $400. You believe it will fall further in the future, so you don’t want to close your short position, but you would like to protect your gains. You can go long 10 AAPL Jul 405 calls @2 to protect your position. Now if the price of Apple rises to $500, you will have the right to buy 1,000 shares