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Four Ways to Hedge Your Stock Bets With Options


Protecting your bets with option contracts.

Cover Your Shorts

Our last hedging alternative is a little different from the rest, as it involves using calls rather than puts. Short sellers might get a lot of grief and take a lot of blame, but they need to hedge sometimes, too, just like everybody else.

As you may have already noticed, we usually prefer put options over short selling. However, rest assured that we won't chastise you if you decide to sell a stock short. However, it can be a risky strategy if the underlying stock unexpectedly treks higher.

How do you hedge a short stock position? Simply purchase a long call. By buying to open a call option on the stock you've shorted, you gain the right to purchase the stock at the strike price of the contract.

For example, say you shorted Stock XYZ when it was trading at $30. The shares have since declined to $18, proving your theory correct. But, unfortunately, the equity surged to $24 after a positive earnings report, and your profits are dwindling rapidly.

In order to hedge your position, you could buy to open an out-of-the-money call option -- in this case, the $25 strike would work. Then, you could lock in a profit of $5 on the trade, because you've obtained the right to purchase the shares at $25 each. Even if XYZ rallies up to $32, which would have placed your unhedged short sale at a loss, you can still come out victorious.

In summation, there's no limit to the number of ways you can hedge your bets with options. As a final note, however, be sure that you're not hedging when you should be closing out a losing position. It's always a good idea to re-examine your initial rationale for the trade, and make sure your analysis is still sound, before choosing your next move.

This article by Beth Gaston was originally published on Schaeffer's Investment Research.

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Twitter: @schaeffers
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