Sometimes an investment has made substantial gains, but you're not ready to sell the assets just yet. At the same time, you don’t want to risk losing the profit you’ll get by cashing in immediately. When you face this dilemma with call options, you can hedge your position with offsetting put options.
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. 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. The call option is said to be “in the money.” The put option has no value, because you pay more to buy the shares needed to exercise the option than the strike price you are paid. 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.
Call Option Hedging
Suppose you buy a call for a stock with a strike price of $25 per share and pay a premium of $1 per share for the option. The price increases to $30 per share, so the call is in the money. You can exercise it, netting $5 per share minus the $1 premium for a $4 per share profit. 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.
Don’t confuse hedging call options using put options with the "straddle" trading strategy. Options traders use straddles when they aren’t sure which way a stock price will move. In a straddle, you simultaneously purchase offsetting put and call options for the same stock with identical expiration dates and strike prices. If the price changes enough in either direction to cover the cost of the two premiums, you’re in the money. 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.