Options were invented for hedging long before anyone used them to speculate. A hedge reduces the damage from a move against you, at a cost, while keeping some or all of the upside. It is insurance for a position.
Protective put
Own the asset and buy a put. Below the put's strike, every dollar lost on the shares is made back on the put, so the loss is capped. The cost is the premium, which reduces profit if the hedge isn't needed.
Covered call
Own the asset and sell a call above the current price. You collect premium as income, but give up gains above the strike. It offers only a small cushion against falls, the premium received.
Collar
Buy a put and sell a call, using the call premium to pay for the put. Losses below the put strike and gains above the call strike are both capped, often for little or no net cost.
Hedging futures and portfolios
The same ideas apply to futures and to portfolios of stocks. A trader holding a long ES position overnight might buy an out-of-the-money SPX or ES put to cap the damage from a gap down. A portfolio manager might buy index puts to protect a basket of stocks.
Worked example
You hold 1 ES contract at 5,000 ($50 per point) overnight, ahead of a major data release.
A next-day 4,950 ES put costs 12 points ($600). If the index gaps to 4,880, the futures lose 120 points ($6,000) but the put is worth at least 70 points ($3,500): the net loss is about $3,100 instead of $6,000.
| Hedge | Cost | Downside | Upside |
|---|---|---|---|
| Protective put | Premium paid | Capped below the strike | Unlimited, minus the premium |
| Covered call | None (earns premium) | Only cushioned by the premium | Capped at the strike |
| Collar | Little or none | Capped below the put | Capped at the call |
Key takeaways
- A protective put caps losses on a position at the cost of the premium.
- A covered call earns income but caps the upside.
- A collar caps both sides, often at little or no net cost.
- Unlike a stop-loss, an options hedge still works when price gaps.