Hedging and Income from Options

Kerry Back

Covered Calls

Sell a call on a stock that you own.
Usually sell an out-of-the-money call.
Example: own a stock with price = $60, sell an $80 call
Caps your upside at $80.
Probably, stock ends < $80 and you just keep the premium
No margin required. Stock serves as collateral.

Protective put

Protect the downside of an asset you own by buying a put.
The portfolio value cannot fall below the put strike, because the put is an option to sell at the strike.
Normally use an out-of-the-money put.
- Example: you own an asset worth $50. Buy a put with strike $40.
- Insurance against a drop in price
- Buying an in-the-money put is buying insurance against a loss that has already happened.

Collaring a long position

Buy an out-of-the money put for protection and sell an out-of-the-money call to help pay for the protection.
Give up some upside for downside protection.
Example: own a stock at $60, buy a put at $50, sell a call at $70
Zero-cost collar: price of call = price of put, so no out of pocket cost for protection.

Collaring Apple on Feb 3, 2023

Apple was trading at $155.80
Could buy a Mar 17 $140 put at the ask price of $1.22
Could sell a Mar 17 $170 call at the bid price of $1.31

Protective call

If you are short an asset, you can protect against the price spiking by buying a call.
Your liability cannot exceed the call strike, because the call option can be exercised at the strike, and the asset you acquire can be used to cover the short.
Usually use an out-of-the-money call.

Collaring a short position

Buy an out-of-the-money call for protection
Sell an out-of-the-money put to help pay for it
Example: short a $60 stock, buy a call at $80, sell a put at $40
Giving up some potential gain to limit your maximum loss

Collaring a short position in Apple on Feb 3, 2023

Apple was trading at $155.80
Could buy a Mar 17 $170 call at the bid price of $1.31
Could sell a Mar 17 $140 put at the ask price of $1.22