Call and put options are contracts that are known as derivatives because they derive their values from other securities, contracts or assets. Puts and calls provide a flexible way to hedge your investments. Hedging is a strategy in which losses in one position are fully or partially offset by gains in another position. You can also use options to speculate on investment ideas at a relatively low cost. You can hedge a call option with a put option once you understand how options work.
Put options can hedge call option positions in many ways.
Understanding Option Contracts
Puts and calls share certain characteristics:
- Option purchasers hold a long position. Option sellers, also called writers, hold a short position.
- Options trade on public exchanges where a clearinghouse mediates all trades between buyers and sellers.
- Options specify a specific asset price, called the strike price, from which you measure the option’s value.
- Options have an expiration date when the contract expires. You can buy options that expire in periods ranging from a few minutes to more than a year. Most options have standard weekly and monthly expirations.
- You can exercise an option, which means you can buy or sell the underlying asset.
- You can exercise American-style options at any time until they expire.
- You can exercise European-style options only at expiration.
- Options give purchasers the right, but not the obligation, to buy (with a call) or sell (with a put) a fixed quantity of the underlying asset. For example, an American-style put on XYZ Corp stock gives the put buyer the right to sell 100 shares of XYZ at the strike price at any time until expiration.
- Option traders pay a dynamic price, called a premium, to buy options. Option writers collect premiums for writing options.
- You can close out an option position at any time until expiration. You close out an option by selling the options you bought or buying back the options you wrote at the current market price of the option.
Buying Puts and Calls
You buy a call or put by paying the premium, which depends on several factors, including:
- Intrinsic value: This is the relationship between the strike price and the asset price. For example, if XYZ stock sells for $42 a share, you could purchase a $40-strike call for no less than $200 (i.e., 100 shares x ($42 price -$40 strike)). You actually will pay more than $200, which is called the option’s intrinsic value, due to other value components. Similarly, a $45-strike put would have an intrinsic value of $300 (i.e., 100 shares x ($45 strike - $42 price)).
- Time value: This is the time left until contract expiration. The more time left until expiration, the higher the time value. That’s because the chances that an option will gain value increase with time. An option could have no intrinsic value (such as $45-strike call on the XYZ stock), but sell for a positive premium due to its time value. Time values dwindle to zero as expiration approaches.
- Volatility: Highly volatile underlying assets will cause option writers to demand a higher premium when they sell options, because the options have a greater chance of gaining value.
- Interest rates: High interest rates cause call premiums to expand, but depress put premiums. The effect is due to the difference in the cost of buying, say, a call on XYZ stock and directly buying 100 shares of the stock. The money saved by purchasing the call instead of the shares can earn interest, so higher interest rates benefit call prices. The opposite effect occurs with put prices.
- Dividends: When a stock pays a dividend, its share price falls to reflect the distribution of equity to shareholders. Therefore, stock dividends decrease call values because call buyers benefit when stock prices rise. Conversely, puts gain value because put buyers benefit when the stock price falls.
The Role of the Option Writer
The option buyer pays an initial premium, and that is the maximum loss the buyer can sustain. That’s because, at worst, a long option position will expire worthless. The option writer collects the initial premium and then hopes the option will expire worthless. That’s because the option writer must respond (by spending money or foregoing profit) if the buyer executes the option.
If a call buyer exercises an option, the call writer must deliver the underlying asset at the strike price. That means the call writer must either go into the market to buy the shares (i.e., the option was a naked call) or use shares already owned (i.e., a covered call). In either case, the shares are worth more than the strike price, or else the call buyer wouldn’t execute the option. The call writer must absorb the loss (or forfeited profit) represented by the difference between the asset price and the strike price.
Example of a Call Trade
Suppose a call writer sells a naked 3-month, $45-strike XYZ stock call for $150 when the shares trade for $42. The premium is all-time value, not intrinsic value, because the call strike price is above the asset price. Suppose the shares rise to $50 in two months. The call buyer can execute the call and purchase 100 shares of the stock for $45 each ($5 below market price) from the call writer. The call writer must buy the 100 shares of stock for $5,000, deliver the shares to the call buyer, and collect $4,500 from the buyer (i.e. 100 shares x $45 strike price). That’s a $500 loss to the writer, but the writer collected the initial $150 premium, so the writer’s net loss is $350.
Conversely, the buyer can immediately sell the delivered shares for $50 each, collecting a profit of $5 x 100 shares, or $500. After accounting for the original premium, the call buyer earns a $350 net profit. Note that the call writer has unlimited risk, since there is no limit on how high the asset price will rise. Had the call writer sold a covered call, the risk, if any, would be limited to the difference between the price the writer originally paid for the shares and the strike price.
Puts work the same way but in the inverse direction. When a put buyer executes the put, the put writer must buy the underlying asset at the strike price from the put buyer. The put writer’s risk cannot exceed the strike price of the asset, since this is how much it will cost the writer if the put is exercised. Put writers can write covered puts by first shorting (i.e., borrowing and selling) the underlying asset.
Note that the call buyer can simply sell the call for its current market price instead of executing the call. If the shares sell for $50, the $45-strike call option might sell for $700 (the actual price depends on the valuation factors). The new call buyer pays $700 to the original call buyer, who makes a net profit of $700 minus the $150 premium, or $550. In this case, the original buyer makes more by selling the option than by executing it. The $200 difference selling and executing the call option is the remaining time value in the option.
Call Option Hedge Calculation
You can use a put option to lock in a profit on a call without selling or executing the call right away. For example, the XYZ call buyer might purchase a one-month, $50-strike put when the shares sell for $50 each. The cost of the put might be $100. Possible outcomes include:
- If nothing else changes until expiration, the buyer takes a $250 profit ($500 intrinsic value at expiration – $150 call premium - $100 put premium).
- If the shares fall below $50, the loss on the call is hedged by a gain on the put.
- If the share price rises to $51, the buyer recoups the put premium.
- If shares rise to, say, $55, then the buyer makes a $750 net profit at expiration ($1,000 intrinsic value of call – $150 call premium - $100 put premium).
Sophisticated Option Hedging
There are many hedging strategies involving puts and calls. For example, you could hedge a short call with a long put, in which the premium collected on the short call partially offsets the premium paid for the put and the risk that the call will gain value. You can hedge puts and calls with different quantities of each contract, different underlying assets, different strike prices, and/or different expiration dates. Each strategy requires a thorough understanding of its risk/reward profile so that a trader knows the maximum amount at risk.
One of the most popular hedging strategies is called a spread.
Types of Option Spreads
An option spread is a strategy with offsetting positions to reduce risk using options with the same underlying asset but having different strike prices and/or expiration dates. There are three basic types of spreads:
- Horizontal spread: Also called a calendar spread, this Involves offsetting options with the same strike price but with different expiration dates. They are set up to take advantage of time-value decay. That is, the options with the closer expiration date will lose value faster than further-out options. Technically, this is called theta decay. In one type of calendar spread, you sell near-term calls or puts and sell longer-term calls or puts. The premium you collect from selling the option reduces your overall cost. Once the near-term option expires, you have a naked put or call, which you hope will gain value before it expires.
- Vertical spread: This spread uses options with the same expiration dates but with different strike prices. It is typically used to offset the net premium you pay to establish a hedge. For example, you can buy a three-month XYZ call (with XYZ shares selling at $50) with a $50 strike for $400 and sell a three-month one with a $55 strike for $100. The $100 you receive cuts the net premium from $400 to $300. The maximum value of the spread is $500 when XYZ shares rise to $55 or higher. Vertical spreads can be bull spreads (that profit from rising prices) or bear spreads (profiting from falling prices).
- Diagonal spread: This is a combination of a horizontal and vertical spread, with different expiration dates and different strike prices.
Spreads form the basis of even more complicated strategies, such as collars and iron condors. The latter involves purchasing or writing two vertical spreads, one with puts and one with calls. You use this strategy when you have no strong opinion on the market’s direction.
One last spread was invented by a witty trader. It’s called the alligator spread, because the commissions eat you alive.