Hedging with Options

Hedging with Options. How to use covered call options and covered put options to hedge your stock positions effectively.

Hedging with Options: Covered Call Options

The covered call option is arguably the most popular option hedging strategy used at present. While many investment professionals also use this strategy, it remains highly risky if you use the strategy incorrectly.

A covered call provides protection against decreases in the price of a long underlying position, or increases in the price of a short underlying position. This has limited profit potential and has the risk of substantial loss (albeit less than that for an unprotected position).

When to use Covered Call Hedging

When you observe a bullish to neutral market. That is, if you expect a slow rise in the price of the underlying asset with low risk of a decline. It protects you from possible decreases in a long stock position, provided that it is bullish enough to stay above the breakeven point.

Stock Option Trading Strategy: Covered Put Options

With the covered put option hedging strategy, you seek to profit from a possible increase in the price of a short underlying asset. In this case, you sell the underlying asset and sell a put in order to cover the position of the underlying asset.

This is a very risky trade as you would need to short sell the underlying stock on a high margin. Your maximum risk in this trade is unlimited, while your maximum profit is limited.

Your maximum reward with this hedging strategy is the difference between the initial price of the short underlying asset and the strike price of the short put added to the credit received for the option premium.

When to use Covered Put Hedging

You should use covered put options to hedge your short assets; when used in a bearish market, it protects you from possible increases in a short stock position – provided that it is bearish enough to stay below the breakeven point.

Covered calls and covered puts are both high risk option strategies. Covered puts in particular should only be attempted by the highly experienced trader, since there is unlimited risk and you would also be trading on margin.