Page 331

decide not to sell those contracts at the expiration, you can exercise them, meaning that you can sell your 200 shares of Ford for $50 as specified by those 2 FMJ contracts. Either way you will end up with no loss as you have insured yourself by hedging (Well, there is a loss based on the $400 you paid for those options which works out to $2 per share. But if you look at them as pure insurance, then perhaps the loss is justified in this case).

This kind of hedging is sometimes referred to as a protective put, where the options protect your long stock positions. Just like buying insurance when you can choose your level of coverage, you could do the same with protective options. In our last scenario, instead of buying 2 FMJ contracts, you might have decided to buy only one. This would have cut your January coverage in half, but at the same time rather than paying $400 for two contracts, you would have paid $200 for one contract protecting only 100 shares of Ford. Or instead of buying puts for the month of January, you may have wanted to buy put LEAPS with two years to go for a two-year coverage. Of course you would have had to pay more for those LEAPS but you would have gained the longer protection time. Finally, rather than buying FMJ contracts you might have decided to buy FMI (January 45 put) contracts. With this strategy you would have paid only a $1/2 premium (rather than $2 for FMJ) but the protection would have kicked in if Ford fell below $45, leaving you unprotected for the first $5 drop in the stock price (You could think of this as a deductible in insurance lingo). This gives you an almost limitless variety of hedging levels, but just like anything else, you get what you pay for.

Another hedging strategy used by some investors is to protect a short stock position by buying a call option against that. This is sometimes referred to as a synthetic put. Suppose you have shorted 200 shares of Ford at $50 in early January. To protect yourself against the possible …