Options and hedging

Options are contracts, which give the owner the right, to buy (call option) or to sell (put option) a specific amount of an underlying asset for a specific price (exercise price) only at the end (european option) or at any time prior to the specified expiration date (american option). For this option right, the owner has to pay a premium, the option price, at the conclusion date. The opposition of the contract, the seller of the option, has the obligation, to sell (call option) or to buy (put option) the underlying asset at the exercise price if the owner exercises the option.

Collar: A collar consists of holding an underlying asset and simultaneously buying a put option (long put) and selling a call option (short call) of this underlying asset. Because of the long put, the collar hedges against losses of the underlying asset. But the short call limits the possibility of participation on the gains of the underlying asset.

Covered short call (written call): A covered short call consists of holding an underlying asset and simultaneously selling a call option (short call) of this underlying asset. Although in the literature exists the name call hedge, the covered short call is not an actual hedge strategy. It is only possible to hedge losses of the underelying asset to the amount of the option price, higher losses will be reduced to this amount. On the other hand it is not possible to participate on gains of the underlying asset, because in this case, the option will be exercised, i.e. the seller has to deliver the underlying asset.

Hedge strategies: A hedge strategy is the intentional reduction of the loss risk (downside risk) of an underlying asset to the debit of the gain chance. Usually hedge strategies are done with derivative securities, e.g. options.

Put hedge (protective put): A put hedge is a hedge strategy consisting of holding an underlying asset and simultaneously buying a put option (long put) of the same one. This combination leads to an asymmetric gain/loss position at the expiration date: on the one hand there is an effective hedge against losses and on the other hand it is possible to participate in the gains of the underlying asset, but reduced to the amount of the option price.

Literature: Hull (1993), Steiner & Bruns (1993)

Entry by: Michael Adam

November 10, 1997
Direct questions and comments to: Glossary master