Sometimes an
investment has made substantial gains, but you're not ready to sell the assets
just yet. At the same time, you don’t want to risk losing the profit you’ll get
by cashing in immediately. When you face this dilemma with call options, you
can hedge your position with offsetting put options.
Calls and Puts
When you
purchase call options on stock or another underlying security, you receive the
right to buy shares at a designated price called the strike price. You can
exercise your right to buy until the option expires, but you are not required
to do so. Put options work exactly the same, except you get the right to sell a
security instead of buy it. Suppose you buy a call and put option contract for
the same stock at the same strike price. If the stock price increases, you
would exercise the call to buy shares at the lower strike price, and then sell
at market value, netting a profit. The call option is said to be “in the
money.” The put option has no value, because you pay more to buy the shares
needed to exercise the option than the strike price you are paid. However, if
the price of the stock falls instead, the call option would have no value and
the put option would be in the money.
