And what if your stock is falling? Your
losses are capped. The max loss for this
kind of hedge is the difference between
the stock’s price and the put’s strike price,
which is $5 ($175 – $170), plus the cost
of the put ($5), for a max risk of $10, plus
BUY STOCK + BUY PUT + SELL CALL
PRO: A very low-cost hedge with a better
breakeven than a put hedge.
CON: The upside potential of your long
stock is limited to the strike price of your
long call. The protection of your stock position generally kicks in only at the strike price
of the long put.
VOL SCENARIO: Collar hedges can be
placed in any volatility backdrop because at
any given time the volatility premium in the
short call will typically offset the volatility
premium in the long put.
If you think you spot a correction coming,
but you can’t stand the idea of paying for
a long put hedge, the collar can get you as
close to a no-cost hedge as it gets. This hedge
combines a long OTM put with a short O TM
call wrapped around your stock—the “
collar.” (See Figure 2.) The beauty of this strategy is that the call premium you collect helps
pay for some or all of the put hedge.
Using the same prices as in earlier examples, the $5 premium collected from the
sale of the 180 call offsets the $5 premium
of the 170 put. If the stock drops below
$170, your loss is limited to $5. Likewise,
if the stock moves above $180, your gain is
limited to $5.
TRADE—BUY STOCK + SELL CALL
PRO: Credit from the short call reduces the
breakeven of your stock position.
CON: The upside potential of the long stock
is limited to the strike price of the call. Hedging capacity is limited in a selloff.
VOL SCENARIO: Medium volatility is preferred for higher credit premiums to sell the
short call. The catch is that higher volatility
tends to minimize the protection of the
This is a one-option strategy—you sell one
call for every 100 shares of stock you want
to hedge. The strategy consists of a short
call, typically ATM or O TM. (See Figure 3.)
The covered call doesn’t provide a lot of
downside protection, but rather, reduces the
cost of your original stock position. For this
reason, it’s better suited to late-stage bull
markets that could be headed for a correction, or even modest early-stage pullbacks
where volatility isn’t exceedingly high.
Say you own a stock that’s trading at $175
and you sell the 180 call for $5 ($500 per
option). This reduces your cost basis by $5,
and as long as the stock remains below $180
at expiration, the option will likely expire
worthless. Keep in mind that in reality, an
option that’s $5 OTM can have high vol.
This leaves room for the stock to profit $5
on the move from $175 to $180. If you add in
the $5 premium, that gives you a potential
profit of $10. But you could be forced to sell
your stock at the strike price if the stock
moves above it. And, beyond the $5 reduction in your cost basis, you still have the risk
of loss. You can do this strategy multiple
times in bull markets, and even when the
market is on its way down, so those premiums can add up over time.
THE RISKS POSED BY INDIVIDUAL STOCKS
can be different from the risks that affect
your portfolio as a whole. But that doesn’t
mean there’s nothing you can do about it.
Hedging individual high-flyers, or stocks
that can get hit solely because of the sector
they’re in, is a strategy that traders could
use to reduce the risk these stocks pose,
while giving them the chance to profit.
*Prices discussed for the purchase and sale of options in this article do not include transaction costs.
For more on the risks of trading option spreads,
see page 37, #4.
FIGURE 3: Covered call. Risk graph of a short 180
call. For illustrative purposes only.
FIGURE 2: Collar. Risk graph of a long stock collared
with a 170 put and a short 180 call.
For illustrative purposes only.
Stock Short call