Section 5.4 – Hedging & Covered/Uncovered Options

  • πŸ”Ή Key Concept: Hedging

    • Hedging means protecting an existing position from an unfavorable price movement.

    • When hedging with options, the investor pays the premium to reduce potential loss.

    • Hedging is like insurance β€” you give up a small cost (premium) to limit risk.

πŸ”Ή Hedging a Long Stock Position (Protective Put):

  • Investor owns the stock β†’ β€œLong the stock.”

  • To protect against a price drop, investor buys a put option.

  • The put allows the investor to sell the stock at the strike price even if the market price falls.

  • This locks in a selling price and limits loss.

Formula:

Breakeven = Price paid for the stock + Premium paid

Example:

  • Customer owns 300 LMN shares at $70/share.

  • Buys 3 LMN 70 puts @ $2 to hedge.

  • Breakeven = $70 + $2 = $72/share.

  • If stock drops below $70, investor can exercise the put and sell at $70.

  • If stock rises above $72, investor profits without using the put.

πŸ”Ή Hedging a Short Stock Position (Protective Call):

  • A short sale means the investor sells borrowed shares, hoping the price will drop.

  • The investor must later buy back the shares to return them.

  • If the price rises, losses can be large.

To hedge, investor buys a call option β€” this gives the right to buy the stock at a fixed strike price, limiting potential loss.

Formula:

Breakeven = Price the stock was sold for – Premium paid

Example:

  • Investor sells short 200 LMN shares @ $70.

  • Buys 2 LMN 70 calls @ $2 to hedge.

  • Breakeven = $70 – $2 = $68/share.

  • Profit if stock drops below $68.

  • If stock rises to $100, investor exercises calls and buys shares at $70, avoiding a huge loss.

πŸ”Ή Covered vs. Uncovered Calls:

Covered Call

  • Writer owns the underlying stock.

  • If the call is exercised, they can deliver the stock they already own.

  • Low risk since no need to buy shares in the market.

Example:

  • Long 100 shares XYZ @ $40

  • Short 1 XYZ Jul 45 call @ $3

  • If exercised, writer sells shares at $45 (small gain, minimal risk).

Uncovered (Naked) Call

  • Writer does NOT own the underlying stock.

  • If the call is exercised, they must buy shares in the open market to deliver.

  • Since stock prices can rise infinitely, potential loss is unlimited.

Example:

  • Short 1 XYZ Jul 45 call.

  • If stock rises to $100, writer must buy at $100 and sell at $45 β†’ massive loss.

Next Section

Hedge

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Hedge 〰️

✺ Review questions ✺

  • A. To increase profits
    B. To protect against loss
    C. To speculate on price moves
    D. To avoid paying taxes
    βœ… Answer: B – Hedging protects an existing position from price movements that could cause a loss.

  • A. $47
    B. $50
    C. $53
    D. $45
    βœ… Answer: C – Breakeven = Stock price + Premium = $50 + $3 = $53.

  • A. Long call
    B. Short call
    C. Long put
    D. Short put
    βœ… Answer: A – A long call allows the short seller to buy shares at a fixed price, limiting loss.

  • A. Covered calls have unlimited risk.
    B. Uncovered calls have unlimited risk.
    C. Covered calls cost more to write.
    D. Uncovered calls guarantee profit.
    βœ… Answer: B – Uncovered calls are risky because the writer may need to buy shares at any market price.

  • A. $72
    B. $68
    C. $70
    D. $66
    βœ… Answer: B – Breakeven = Sale price – Premium = $70 – $2 = $68.