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upside move by Ford (which translates into a loss for you) you could buy 2 FAJ (January 50 call) contracts. If Ford falls to $40 by FAJ's expiration date, those contracts will expire worthless and you take a $10 per share profit on your short position. But if instead Ford climbs to $60 by that time, you would have a $10 loss per share on your short position, but your FAJ contracts would now have a $10 premium which can cover your $10 per share loss if you sold them. Or you can simply exercise the two FAJs at expiration, which means that 200 shares of Ford would be assigned to you at $50, which you can then use to cover your 200-share short position. No loss either way, except for the premium and commission you pay for the FAJ contracts. In this scenario, your protection only lasts until the January expiration date, but just like before you could buy longer term options or even LEAPS to extend your protection further into the future.

At times, financial institutions and mutual fund companies use hedging to protect against losses. Many of them use index options to hedge against the variety of stocks they have in their portfolios. Using index options as a hedge is easier and more cost effective for them than hedging against each individual stock in their portfolios. And since many professional stock portfolios are sector- or index-based anyway, a corresponding index hedge would provide sufficient coverage for their collection of investments. Hedge funds, which we will cover in the next chapter are a good example of portfolios whose managers use hedging techniques to protect against sharp losses.

Finally for the speculators, pure options trading offers a perfect vehicle to invest risk capital in. As options come in all different levels of risks, a trader should be able to effortlessly pick the right trading technique that suits his risk tolerance. For those who may still want a bit of safety, LEAPS offer a great choice. And for the thrill seekers, short-term options maybe a good fit. I remember that on a few occasions a …