Just as we have a protective put for a long position, we can also have a protective call for a short position. That is what will apply to you in this case. The best use of a call option is to hedge or protect your risk when you are short on the stock or you or short on futures. By attaching a call option of higher strike to the short position, you are basically hedging the worst-case risk that may arise in your short position. How exactly does this work?

Existing Position

SBI at Rs.220

SBI at Rs.255

SBI at Rs.290

Short on SBI Futures at Rs.253

Profit on short Futures – Rs.33 (253-220)

Loss on short Futures – Rs.-2 (253-255)

Loss on short futures – Rs.-37 (253-290)

How to hedge

Loss on the Call Option– Rs.-3 (premium)

Loss on the Call Option – Rs.-3 (premium)

Profit on Call option – Rs.+32 (290-255-3)

Buy SBI 255 Call at Rs.3

Net profit / loss

Net profit / loss

Net profit / loss

Max risk = Rs.5

+Rs.30

Rs.-5

Rs.-5

As can be seen in the above case the maximum loss on the hedge is limited to (Rs.-5), irrespective of how high the price of SBI goes. That is the power of hedging with a call option. How is this maximum loss arrived at this case? It is the sum total of the strike gap (255 – 253) and the cost of the call premium of Rs.3. That is how your maximum loss is pegged at Rs.5. Even if the stock goes up to Rs.400, your loss will not cross Rs.5.

Just as we have a protective put for a long position, we can also have a protective call for a short position. That is what will apply to you in this case. The best use of a call option is to hedge or protect your risk when you are short on the stock or you or short on futures. By attaching a call option of higher strike to the short position, you are basically hedging the worst-case risk that may arise in your short position. How exactly does this work?

Existing PositionSBI at Rs.220SBI at Rs.255SBI at Rs.290Short on SBI Futures at Rs.253

Profit on short Futures – Rs.33 (253-220)

Loss on short Futures – Rs.-2 (253-255)

Loss on short futures – Rs.-37 (253-290)

How to hedgeLoss on the Call Option– Rs.-3 (premium)

Loss on the Call Option – Rs.-3 (premium)

Profit on Call option – Rs.+32 (290-255-3)

Buy SBI 255 Call at Rs.3

Net profit / lossNet profit / lossNet profit / lossMax risk = Rs.5

+Rs.30Rs.-5Rs.-5As can be seen in the above case the maximum loss on the hedge is limited to (Rs.-5), irrespective of how high the price of SBI goes. That is the power of hedging with a call option. How is this maximum loss arrived at this case? It is the sum total of the strike gap (255 – 253) and the cost of the call premium of Rs.3. That is how your maximum loss is pegged at Rs.5. Even if the stock goes up to Rs.400, your loss will not cross Rs.5.