Buying Call Options for Protection - dummies

Buying Call Options for Protection

By Paul Mladjenovic

Most speculators understand that you can buy calls for bullish speculating and that you can do covered call writing for income. But on some occasions, calls can be a form of hedging. When would you use call options for protection?

If you’re doing short selling because you think that a particular stock or asset is a good bearish candidate, consider buying a call option against your short position as a form of insurance.

For example, if you’re shorting 200 shares of MMC Corporation at $50 per share, then consider buying two calls on MMC at $50 or $51 if possible. Why two calls? An option contract covers 100 shares, so two contracts would give you more coverage.

Going short is a form of speculating. The danger is that the stock you’re shorting will reverse and rally upward, meaning that you’ll incur losses. Because a call option gains value when the underlying stock is increasing, it works as a good hedge or form of insurance against unlimited losses.

Because shorting a stock is typically a short-term pursuit, you don’t need to buy long-term (also called long-dated) call options. If you see yourself shorting a stock for two or three months, then consider getting an option for four months, giving you some cushion on the time. Buying the short-term call option can be an inexpensive way to limit your potential loss.