Quick Answer
Combine options with stock for income, hedging, and defined risk. Buying an option is a full hedge with defined loss; selling one is only a partial hedge equal to the premium. Calls break even at strike plus premium; puts at strike minus premium. Protective puts are the only full hedge for long stock.
The whole unit on one sheet: the four single-option positions, the covered and protective combinations, the currency and yield-based hedges, and the break-even math the exam loves.
The Four Single-Option Positions
- Long call: bullish. Max gain unlimited, max loss the premium paid, break-even strike plus premium.
- Short call: neutral to bearish. Max gain premium received, max loss unlimited if uncovered (capped if covered), break-even strike plus premium.
- Long put: bearish. Max gain strike minus premium (stock to zero), max loss premium paid, break-even strike minus premium.
- Short put: neutral to bullish. Max gain premium received, max loss strike minus premium (stock to zero), break-even strike minus premium.
Stock-and-Option Strategy Table
| Strategy | Construction | Max Gain | Max Loss | Break-Even |
|---|---|---|---|---|
| Covered call | Long stock + short call | (Strike - stock cost) + premium | Stock cost - premium | Stock cost - premium |
| Covered put | Short stock + short put | (Short sale price - strike) + premium | Unlimited | Short sale price + premium |
| Protective put | Long stock + long put | Unlimited (minus premium) | (Stock cost - strike) + premium | Stock cost + premium |
The One-Liners That Win Points
- Buy an option = full hedge (defined loss, right retained). Sell an option = partial hedge (only the finite premium as a cushion).
- Protective put is the ONLY basic full hedge for long stock. "Best protection" for a stockholder = buy a put, never sell a call.
- Long stock full hedge = buy put; short stock full hedge = buy call. Long bonds full hedge = buy yield-based calls; the partial hedge always sells the opposite.
- Foreign currency: receive = buy puts, pay = buy calls. A U.S. investor holding foreign securities has the same exposure as an exporter, so buy puts.
- Yield-based options reverse the logic: to hedge long bonds against rising rates, buy yield-based CALLS, not puts (rising yields hurt bonds and make yield calls profitable).
- Index puts hedge systematic (market) risk only, never company-specific (unsystematic) risk.
- Every contract represents 100 shares (or the $100 index multiplier), so multiply per-share numbers by 100.
Numbers to Lock In
| Item | Rule |
|---|---|
| Single call break-even | strike + premium (ADD) |
| Single put break-even | strike - premium (SUBTRACT) |
| Long option max loss | premium paid |
| Naked (uncovered) call max loss | unlimited |
| Covered call max gain | (strike - stock cost) + premium, capped |
| Covered put max loss | unlimited (stock can rise forever) |
| Protective put max loss | (stock cost - strike) + premium |
| Contract / index multiplier | 100 shares / $100 per index point |
| Portfolio hedge contracts | portfolio value / (index level x $100) |
| Currency contract size | 10,000 units (Japanese yen 1,000,000) |
| Yield-based strike | represents a yield; a 45 strike = 4.5% |
Memory Aid: Receive = Puts, Pay = Calls
For foreign currency hedging, ask one question: will you receive or pay the foreign currency? Receive foreign currency (exporter, foreign-security holder) = buy puts. Pay foreign currency (importer) = buy calls.
Top Gotchas
- Calls always ADD, puts always SUBTRACT for break-even, whether you are the buyer or the seller; both sides of one contract share the same break-even.
- A covered call caps your upside at the strike plus premium and lowers break-even below the purchase price; it is a partial hedge, not full protection.
- A covered put writer has unlimited loss (stock can rise without limit); a covered call writer's loss is large but limited (stock can only fall to zero).
- When an option is exercised, use the STRIKE price, not the market price, for that transaction; the premium always stays in the ledger even when the option expires worthless.
- Index options settle in CASH the business day after exercise and are European-style (no early assignment); equity options are American-style and physically settled.
- Early assignment risk on a covered call rises near an ex-dividend date when the call is in-the-money and remaining time value is less than the dividend.
- Foreign currency options are physically settled; do not confuse them with cash-settled index or yield-based options.
One-Breath Recap
Buy an option for a full hedge with defined loss; sell one for only the premium as a cushion. Calls break even at strike plus premium and puts at strike minus premium, the protective put is the only full hedge for long stock, and currency and yield-based hedges flip the intuition (receive buys puts, pay buys calls, and long bonds buy yield calls). Track every cash flow, use the strike on exercise, and multiply by 100.
Need more than the recap? This is a condensed summary. If it is not enough, read the full Basic Options Strategies unit for the complete lesson.