All investors are looking for ways to reduce risks associated with their investing strategies.  The problem is, the more risky the investment the greater the return (usually).  One of the ways that investors solve this problem is called a hedge strategy.

 

Another option strategy, the hedge uses one position to protect another.  On of the most common methods is the purchasing of a put for every 100 shares of stock owned.  This is a very conservative strategy, the put providing downside protection for the stock.  This is called a married put as the put is directly linked to the underlying stock.

 

A little more aggressive strategy is called the reverse hedge.  In a reverse hedge, more options than necessary are bought, thus not only providing the required risk protection but also increasing the profit potential for any unfavorable movements.

 

Example:  2 puts are purchased to cover 100 shares of XYZ stock.  Only 1 put is required but any downside movement of XYZ will provide twice the profit from the puts.

In a variable hedge, the two sides compliment one another but one side has more options than the other.

 

Example:  Buying 3 calls and writing 1 call.  The written call is protected by one of the bought calls and the others provides profit.

 

The last hedge is the ratio write.  In this strategy only partial protection is provided.

 

Example:  300 shares of XYZ stock are owned and 4 calls are written.  3 of the 4 calls are covered by the underlying stock while 1 is not.  This strategy can be said to be 3/4 protected.

 

For all option strategies, risk is mitigated but profit is reduced by the premium paid.  In order to realize a profit, the movements of prices must take into account the amount of money paid in premiums and received from writing options.