8.3 Hedging Strategies

Why Hedge with Options

Investors who already own stock use options to limit downside risk or generate income without selling the shares. The Series 7 tests three combinations constantly: the protective put, the covered call, and the collar. For each, know the maximum gain, maximum loss, breakeven, and which client it suits.

Protective Put (Married Put)

The investor owns stock and buys a put. The put acts like insurance — a guaranteed sell price — while the stock retains unlimited upside.

Example — Own 100 XYZ at $50, buy 1 XYZ 50 put @ $3:

The put creates a floor at the strike. If XYZ collapses to $10, the investor still sells at $50, losing only the $3 premium per share. The cost of this insurance is that the stock must rise past $53 to profit.

Exam tip: Pair a protective put with a bullish investor who fears a short-term decline. It is the only single-option hedge that preserves unlimited upside.

Covered Call

The investor owns stock and writes a call against it. "Covered" means the shares are on hand to deliver if assigned, so there is no unlimited risk — unlike a naked call.

Example — Own 100 XYZ bought at $48, sell 1 XYZ 55 call @ $2:

The premium lowers the cost basis to $46, providing modest downside cushion, but gains are capped at $55 because the shares get called away above that strike.

Exam alert: The covered call is the most conservative option-writing strategy and is suitable for income-oriented, neutral-to-slightly-bullish clients.

Collar

A collar layers both hedges on the same stock: buy a protective put (downside floor) and write a covered call (upside cap, premium income). The call premium offsets the put premium, often producing a costless collar when the two premiums match.

Example — Own 100 XYZ at $50, buy 1 XYZ 45 put @ $2, sell 1 XYZ 55 call @ $2:

The collar defines a tight band: the investor cannot lose more than $500 or gain more than $500. It suits an investor who wants to lock in an unrealized gain at low or zero cost and is willing to surrender further upside.

Choosing the Right Hedge

Common Traps

• A protective put's max loss includes any gap between stock cost and strike, plus the premium — do not forget the premium component.
• A covered call is not unlimited risk; the unlimited-risk label belongs to the naked call. The covered writer already owns the deliverable shares.
• In a collar the put strike is below the current price and the call strike is above it; reversing them is a frequent distractor.
• Writing covered calls is suitable for conservative income seekers, but writing naked calls or puts is unsuitable for most retail clients and requires the highest approval level.

Worked Comparison: Same Stock, Three Hedges

Suppose an investor owns 100 shares of XYZ now trading at $50.

• Protective put (buy 50 put @ $3): keeps unlimited upside, floors loss at $300, but the stock must reach $53 to break even.
• Covered call (sell 55 call @ $2): caps gain at $700 (5 points of appreciation plus the $2 premium), cushions the cost basis to $48, but offers no hard downside floor.
• Collar (buy 45 put @ $2, sell 55 call @ $2): pins the outcome between a $500 max gain and a $500 max loss at zero net cost.

The progression shows the trade-off the exam tests: more downside protection generally means giving up more upside or paying more premium.

Important: On suitability questions, match the strategy to the client's market view and risk tolerance. A retiree seeking income fits a covered call; a long-term holder nervous about a short-term correction fits a protective put; an investor wanting to lock an existing gain cheaply fits a collar. Never recommend naked writing to a conservative income client.