How options hedging works
An option is a contract that gives its owner a right, but not an obligation, to buy or sell something at a set price before a set date. Four building blocks make up every options hedge.
Puts and calls
A put gives its owner the right to sell at the strike price. In plain English, a put lets you lock in a sale price. When the market falls below the strike, the put gains value.
A call gives its owner the right to buy at the strike price. When the market rises above the strike, the call gains value.
The buyer pays a premium for that right. The seller receives the premium and takes on the obligation.
A put option works like a climber's piton. There is still a risk of a fall, but the piton acts as a brake to prevent a catastrophic plummet.
The four building blocks
Each chart shows the profit or loss on the option alone, at expiration, as the market moves from low (left) to high (right).
Buy a put
Pays off when the market falls below the strike. The most you can lose is the premium. This is the core of most hedges.
Sell a call
You collect the premium now, and give up gains above the strike. Often used to pay for a put.
Buy a call
Pays off when the market rises above the strike. The most you can lose is the premium.
Sell a put
You collect the premium now, and take on losses below the strike. Used to lower the cost of a hedge, in exchange for leaving a gap in protection.
Adding options to a portfolio
On its own, a put is a bet that the market falls. Paired with a portfolio you already own, it becomes a floor. The charts below show the whole portfolio at the end of one year. The dashed line is the portfolio with no hedge; the green line is the portfolio with the hedge.
Portfolio plus a put
Losses past the put's strike are offset. Upside stays open, less the premium.
Portfolio plus a put, minus a call
The call pays for the put. Losses are limited below and gains are capped above.
Modeled with Black-Scholes pricing at 18% implied volatility. Hypothetical and illustrative only. Simulator and chart results are modeled, not actual trades or client results, and are not a prediction or a recommendation.
Four questions to ask of any options hedge
When does the hedge start protecting?
The strike of the put sets the point where protection begins.
Are there points where it stops protecting?
Selling a lower put lowers the cost but leaves losses below that strike uncovered.
Are there limits to the upside?
Selling a call caps gains above its strike.
Is the cost known or unknown?
A premium paid up front is a known cost. Gains given up above a cap are an unknown cost, paid only if the market rises.