Call options allow you to profit from a rising stock price while paying a relatively small up-front cost to buy call option contracts. However, if the underlying stock price does not move up as expected, it is possible to lose all of the money paid for the call options. Hedging a call options purchase with some put options would limit the potential losses or lock in some profits if the underlying stock decreases in value.
A call option contract is defined by the underlying stock, the option strike price and the expiration date. The strike price is the stock price at which a call option buyer will buy the stock if she chooses to exercise the contract. A purchased call option is profitable when the underlying stock price rises above the strike price by more than the amount paid for the call option. A put option changes value in the opposite direction, gaining value as the underlying stock price moves down. For any stock, call and put contracts are available in a wide range of strike prices and expiration dates. For each dollar the underlying share price moves, the value of an option contract changes by up to $100.
Options traders have the ability to use puts and calls with different strike prices and expiration dates in many types of combinations. Buying calls to profit from a rising stock price is called a long call strategy. If a call and a put are purchased with the same strike price, the strategy is called a long straddle. If you own call options and buy puts at the same strike price, you will hedge against a falling share price and change your strategy from a long call to a straddle. Once you have purchased the put to change the trade to a straddle, your calls will be hedged against the underlying stock price falling below the strike price.
Buying puts adds a significant cost to your call option trade, increasing the amount the underlying stock must change in value to be profitable. The stock price must move above the strike price by the price of both the call option and the put option to generate a profit. The higher costs reduce the chances of the trade to end with a profit. To profit from the purchased put, the stock must drop below the strike price by the same amount -- the total of the two premiums paid. If you think a stock on which you own calls is going to decline, it may be better to just buy back the calls and use the money you would have spent on the puts to buy calls on another stock with a greater potential for profit.
Hedging a Profit
If you own call options that are in a very profitable position, you can hedge and protect some of that profit by buying put options at a higher strike price than the strike price for the call options. For example, you own call options with a strike price of $25 and the stock has zoomed to $50. This means each call option contract is worth at least $2,500. You could purchase put options with a strike price of $45 and lock in most of the profit. To continue the example, if the $45 strike put costs $300, you are locking in $2,000 of the profit for a cost of $300. If the stock declines, your put hedge locks in a $1,700 profit. If the stock goes up, you continue to make $100 for every $1 gain in the underlying share price.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.