Trading Strategy: Buying Call Options to Hedge a Short Sale

One of the riskiest investment strategies in the financial world involves selling stock short. This involves borrowing stock from your broker and selling it. If the stock's market price drops, you can buy it back at the lower price, pay back your broker and pocket the difference. Problems arise if the stock price doesn't co-operate and instead skyrockets. You can hedge your position by buying protective call options.

Call Options

A call option gives the option holder the right, but not the obligation, to purchase the underlying security at a fixed price, called the strike price, for a set period. If the option isn't exercised before it reaches its expiration date, it becomes worthless and ceases to exist. Call options are traded on major investment exchanges in much the same way that stocks are traded. While owning a call option doesn't give you ownership of the underlying stock, it does give you control over that stock for as long as the option is in force.

Protective Call

Buying a call option to hedge your short position in a particular stock is commonly referred to as buying a protective call. This strategy is designed to limit your losses in the event the market price of your short stock rises. Since a stock's price can rise to unlimited heights, your risk is equally unlimited if you have a short position. With a protective call option in place, you can determine the exact amount of loss you are willing to take. No matter how high the stock price rises, you can always exercise your call option and buy the stock back for the predetermined strike price.

Risk vs. Reward

Buying a protective call option to hedge your short stock position limits your potential loss, but it also reduces your potential reward. The market price of your short stock must fall enough to cover the premium you had to pay for your call option, in addition to commissions and interest, before you make any profit on the transaction.

Alternative Investments

If you are bearish on a particular stock, you can achieve similar results to selling stock short by purchasing a put option. A put option gives the option holder the right, but not the obligation, to sell the stock at a fixed price for a set period. The market price of a put option tends to increase as the stock price decreases. If the stock's price rises, the most you can lose is the amount of the premium you paid for the put option.