Hedging with options - a simple explanation

Hedging simply means an attempt to protect your investments from a loss.

There are cases in which you might want to stay in the market (or in your stock positions) even if you expect a short-term market movement against your holdings. In such times you might need to hedge your positions in order to protect your money (or investments). The reasons could vary - be it the simple will to escape taxation on short-term investments or if you are not sure enough if the profitable movement will continue and you want to lock some profit in.

Options are one of the most widely known tools for hedging. To put it simply the options give you ability to lock in the current price level of your holdings. For that protection you pay a price which usually is the current market price of the particular option.

• If you own some stock and expect its price to decline for some time you can buy a PUT option. This strategy is known as "protective put" or "married put". Such PUT option will give you the right to sell the stock to the writer (seller) of the option at particular price (called the Strike price). In the case of hedging the point is that the strike price would be around the particular price that you want to hedge. Options are standardized contracts which trade by 100, i.e. one put option gives you right to sell 100 shares.
  
  An example:
  
  Let's say you own 500 shares of company XYZ. Their current market price is $15. You bought them at $10. So till now you have an unrealized profit of $2500 (not counting any commissions, etc). You can look at the options available for your stock and choose the PUT option whose strike price is closest to $15. Sometimes there could be only options for different prices - above and below your hedging price (the current market price of the stock). The option whose strike is above the stock market price (that option is called In-The-Money) will be more expensive than the PUT whose strike is below the current market price (the Out-Of-The-Money option). In that case you should choose what you prefer - to pay more and get even a better price than the current market price or pay less and wait for the option to get in the money. Let's say you get the out of the money Put whose strike is at $14 and is sold for $0.5 per option. As you own 500 shares of XYZ you would like to get 5 Put contracts which give you the right to sell 500 shares at $14. Those 5 options would cost you $250. So you give $250 and lock the $14 price level for your stock holdings. In the worst case (when the price goes below $14) you would limit your profit to 500 x 4 - 250 = $1750 and for a definite time (the time till the expiration date of the option) you will eliminate the risk of loss from a further decline in the stock price.
  
• There is an exotic and more aggressive hedging against a short-term drop in the price of the underlying stock - shorting the Call options of the stock. The point is that usually (but not always!) the price of the In the Money Call whose strike is close to the current market price of the underlying stock tends to drop sharply if it goes out of the money.
  The possible profit (which will compensate your loss from the underlying stock) from such a strategy is limited by the price at which the call option is sold short minus the price at which you cover your short options position at a later time. A speculator could also profit from the leverage which options provide compared to the price of the stock itself.
  The loss on the other hand in this strategy could be unlimited if the price of the underlying stock starts to grow and you still have the short calls position opened. All that makes this a complicated and a risky strategy and thus not always suitable for simple hedging purposes.
  
  An example:
  
  If the current underlying price is $13, the price of a $12 strike call option could be $1.05. If you have 1000 shares you could sell short 10 such calls. That would get you $1050. On the next day or two the price of the underlying goes below the $12 limit and stops at $11.80. The loss from the underlying is $1200. The calls could be priced at $0.15. If you close the short position your profit from it would be $900. The whole loss on your investment goes to $1200 - $900 = $300. So by shorting the calls in this example your loss could be $300 and not $1200.
  On the other hand one could short a bigger amount of calls and thus even collect a profit at the end.
  
  Often the choice whether to use protective Puts or to short the Calls depends on the option's delta - that is how much the option's price would change if the price of the underlying stock experiences a change of $1. The deltas are constantly changing and could be checked on the CBOE site.
• A nice strategy in which one could profit from a possible upward movement of a stock while still locking the current price level of the underlying is to simply buy an ATM Call and sell the shares owned. The money from the sell could be put in a risk-free investment. That way the current profit is "locked in" but the investor still would profit from a possible upward movement. The potential loss is limited to the amount of the premium paid for the option while the profit could equal the profit from the rise of the stock price plus the income from the risk-free investment.
  

Hedging with options is not so complicated as trading the options themselves but it still contains a higher level of risk and complexity. Options are not suitable for everyone and as they are more risky tool you should know what you do when you use them even if it's only for hedging of your current stock holdings. You are warned! :)

Below are some links about options:
Wikipedia
Shaeffer's Research
Options Basics: Introduction
Equity Option Strategies at CBOE