Sometimes an investment has made substantial gains, but you're not ready to sell the assets just yet. When you face this dilemma with call options, you can hedge your position with offsetting put options. When you purchase call options on stock or another underlying security, you receive the right to buy shares at a designated price called the strike price.
You can exercise your right to buy until the option expires, but you are not required to do so. Put options work exactly the same, except you get the right to sell a security instead of buy it. Suppose you buy a call and put option contract for the same stock at the same strike price. If the stock price increases, you would exercise the call to buy shares at the lower strike price, and then sell at market value, netting a profit.
However, if the price of the stock falls instead, the call option would have no value and the put option would be in the money. However, there are still a few weeks until the option expires and the price might go up even more. You can hedge the call with a put to protect your gains. To hedge call options with put options, purchase put options equal in number to your call options.
The puts should have expiration dates on or after the call expiration dates. The put option strike price needs to be at, or just below, the current market price of the stock. If the put strike price is above the market price, the puts would be in the money and cost more. You have now hedged the call options. A drop in the share price will add value to the put options at the same rate your call options lose value.
In a straddle, you simultaneously purchase offsetting put and call options for the same stock with identical expiration dates and strike prices. What makes hedging a call option with a put option different is that the put is bought after the call is in the money and the put strike price is higher than the call strike price. He writes about business, personal finance and careers.
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These returns cover a period from and were examined and attested by Baker Tilly, an independent accounting firm. Visit performance for information about the performance numbers displayed above. Skip to main content. Calls and Puts When you purchase call options on stock or another underlying security, you receive the right to buy shares at a designated price called the strike price.
Execution To hedge call options with put options, purchase put options equal in number to your call options. Puts and Calls Options Industry Council: Zacks Research is Reported On:More...