There are two basic choices in hedging a call option position--establishing a short position in the stock or buying put options. Since a call option position is a "long" position--that is, an investment that will profit if the price of underlying stock goes up--in order to hedge that position you must have an investment that will increase in value as the original call position decreases in value.
When hedging, the two investment positions are in an inverse relationship so that one "hedges" (protects) the other from great losses. Hedging is often done when the position is already profitable and you want to protect those profits, so it can be thought of as a form of insurance.
Determine how much of a hedge you want. That is, decide whether you are going to try and protect 10 percent, 20 percent, or even up to 50 percent of the value of your call option position. Once you have decided the percentage, then you can calculate how much you will have to invest to hedge that percent of the value of your calls.
Decide whether you want to hedge your call position by buying offsetting put options or by establishing a short position in the underlying stock. The factors to consider in making this decision are the amount of capital you want to tie up in this hedge and the premium on the put options.
If the premium (extra cost to buy leveraged puts vs. owning the stock) on the puts is relatively low, you almost certainly are better off just buying offsetting puts, but if it is high, you can likely set up a more cost-effective hedge by going short on the underlying stock (this will require more capital).
Execute your call option hedge by purchasing offsetting put options or establishing a short position in the underlying stock. For example, say you had a $10,000 call option position and you wanted to hedge 25 percent of that position. If you hedged the call position using offsetting puts then you could probably do it for between $400 and $1,200 (assuming a reasonably low premium in purchasing the puts).
But if you hedged the calls with a short position in the stock, you would have to invest $2,500 (25 percent of $10,000). The net result of the hedge is you still continue to make some money if the stock price continues to go up (as you only hedged 25 percent), but you will lose less of your profits if it goes down, as your hedge will compensate for 25 percent of the losses.
Put (and call) premiums become high when there is expected volatility in the stock. That is, the stock price is expected to move up or down a lot soon as some kind of big news is due soon (FDA drug approval decision, important court case, buyout-related expectations, etc.). If there is little reason to expect volatility in the stock price, usually the premiums for calls and puts remain low.
- business charts with buy image by Andrew Brown from Fotolia.com