by Mike Scanlin

Hedging is when you take a position to protect against losses in some other position. Rather than put all your eggs in one basket, you put some in one basket and some in another basket which is inversely correlated to the first.

If you are long a certain stock, you might choose to hedge that position by buying some put options for the same stock. That way, if the stock drops you are protected somewhat. You can exercise your puts and receive the strike price per share as a floor price for your investment.

Sounds Good. What's The Catch?

The catch is that hedging is not free. Much like buying insurance, there is a cost associated with hedging (or removing risk) from a position. The cost you pay to buy the put options, for example, is non-zero. If the stock stays flat or rises then you have lost the option premium you paid for those puts.

A Cost-Free Option Hedging Technique

Option hedging techniques range from total protection (buy an at-the-money put; very expensive) to no protection (no hedge). In between are two common partial hedges: (1) buy out-of-the-money puts or (2) sell calls. Buying put options is a simple enough strategy but often the costs are high. Selling call options is a way to generate some income and at the same time get a little bit of a hedge because of the premium you receive. It's not as much of a hedge as buying put options, but it's also cost-free. In fact, you can actually come out ahead in many cases since selling calls is income producing.

Example 1: No Hedge; Just Buy And Hope (Hold)

You buy 100 shares of XYZ at $52.50/share and hold it for 4 months. Maybe you make some money; maybe you lose some money. It's an unhedged long position and could go either way. If it's a high beta (i.e. volatile) stock, or has earnings coming out, or if your position is too big for your portfolio then you may not sleep well with unhedged exposure.

Example 2: Hedging By Buying A Put Option

Same stock purchased but you also buy 1 put option with a strike of 45 and pay $2 (per share) for 4 months of protection. You know that no matter what happens you can get at least $45/share for your stock between today and option expiration. If on expiration day XYZ is higher than $45 then you keep your stock and the put option expires worthless. You've lost $2/share on the option but have had the peace of mind that no matter what happend over 4 months you would always be able to sell your stock for $45/share if you so desired.

Example 3: Hedging By Selling A Call Option

Same stock purchased but you do a weaker form of hedging by selling 1 call option with a strike of 60 that is good for 4 months. You receive $2 (per share) for selling the option. Now, your downside case has gotten potentially worse; if XYZ drops through the floor you will realize the entire loss except for the first $2 (per share).

On the other hand, if XYZ does not drop significantly, and if it stays below 60 by expiration day then on expiration day the option will expire worthless and you've made $2/share on the option trade. The stock may have gone up or down during that time, so it's not easy to say if you've made money overall or not. But you can now sell another call option for the next 3-4 months and earn another batch of income.

If XYZ is over 60 on expiration day then you will be forced to sell your shares for $60/share, so you made $7.50/share on the stock and $2/share on the option, for a total max profit of $9.50/share (which is 18% in 4 months for our example case).

So Which Form Of Option Hedging Is Best?

It depends on your risk tolerance level and how much profit you are willing to give up in order to limit your losses. Buying puts will guarantee you a floor price for your stock but will eat into your profits and might be expensive. Selling calls will generate income, gives you some protection, but also creates a cap on your upside, too. If you do sell covered calls and set the strike price to a level you'd be happy selling your stock for then it's a pretty good plan.

You don't have total downside protection with covered calls but you have to ask yourself if you are so worried about the stock's downside then maybe you shouldn't even be owning it? Maybe sell it and buy something where you're not as worried about the downside case, and then sell calls against that new stock.

Real World Examples

Here are a few stocks selling at or near their 52-week high. Reasonable candidates to write an at the money or slightly out of the money covered call if they are in your portfolio. None of these Jan 21 options have earnings release before expiration. Not a ton of downside protection here, but perhaps a way to get a little extra gain in the 2 weeks before expiration:

Find more like those:   Check out our Covered Call Screener

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.