Stock Options Tutorial - Short Stock Hedging With Options

Stock with Options Practice Questions - For Series 7 exam or other educational tests.

Some more sample option contract examples and how to look at them correctly:

Short 100 Shares of JKO at $65 and is long (buys) 1 OCT 70 JKO Call for $200

First TIP Help is ALWAYS focus on the stock. The option is only there for one of 2 reasons. For income - which this is not because the option was bought or PROTECTION - and that is the case HERE. A call gives the investor the right to buy the stock at 70. That does not effect the main strategy or focus which is the stock position. Stock positions will have more money invested than an option premium in most cases. So whether the stock is bought or shorted - there is $6500 on the line here, or at least there would be without the protection hedge.

Hedging and protection

The maximum loss WITHOUT the call option here would have been unlimited. Selling stock short is extremely risky if left uncovered. You are obligated to buy back or "cover" the short sale and that price is unknown and when the investor buys back the stock is not known. The option is a like a stop loss order but a little better. Better because unlike a stop loss order, an option is only used if YOU choose to. Problem with the call contract is the cost (premium) which will hit your profit potential. If the option were not there, the maximum gain WOULD BE $6500, since the stock could go to Zero. But because the option cost $200,
The maximum gain is $6300

How to figure Break Even

Break even on stock with options together is always cost. Cost spent or net cost received. In this case, the net cost received is $6300, so  the break-even is 63 

The "add on calls and subtract on puts" break even rules with single options does not apply here. FOCUS ON THE STOCK!

Back to the MAXIMUM LOSS. Since we know that would have been unlimited if the stock was shorted naked without a hedge, the maximum loss here is the difference between the short sale of $6500 and where the stock can be bought back (70), which is $500
plus the premium of $200 = $700  THAT IS THE ONLY WAY TO LOOK AT THESE POSITIONS FOR THE SERIES 7 - SERIES 4 or other exam.

Stock positions are the main play. Options are for hedging - Getting income to lower breakeven or protection. You can only protect when you buy the option. Selling is for income.

Try not to memorize these things. Look to make sense out of them. You have enough to memorize (formulas, rules etc.). Options should not be one of them.

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