Quick Answer
Buying an option always provides a full hedge with a defined maximum loss, because you hold the right to exercise at a known strike price. Selling an option only ever provides a partial hedge, because the premium received is a fixed, finite cushion that does not grow when the market moves sharply against you.
This final section ties every strategy in the unit together around one question: did you buy or sell the option? Every hedging scenario on the exam, whether it involves stock, bonds, or foreign currency, reduces to that single distinction.
What Is the Difference Between a Full Hedge and a Partial Hedge?
| Hedge Type | Method | Protection Level | Cost |
|---|---|---|---|
| Full hedge | Buy an option | Defined maximum loss; unlimited or large upside retained | Pay premium upfront |
| Partial hedge | Sell an option | Limited protection equal to premium received; does not cap losses | Receive premium upfront |
The key distinction:
- Buying an option = full hedge (you have a guaranteed right)
- Selling an option = partial hedge (you only have the premium as a buffer)
How Does the Full-vs-Partial Hedge Rule Apply by Position?
| Existing Position | Full Hedge | Partial Hedge |
|---|---|---|
| Long stock | Buy put | Sell call |
| Short stock | Buy call | Sell put |
| Long bonds | Buy yield-based calls | Sell yield-based puts |
| Receiving foreign currency | Buy currency puts | Sell currency calls |
| Paying foreign currency | Buy currency calls | Sell currency puts |
Exam Tip: Gotchas
- Yield-based options reverse the usual call/put logic; buy calls to hedge long bonds against rising rates.
- Currency options: receiving foreign currency = buy puts, paying foreign currency = buy calls.
Why Does Buying an Option Provide a Full Hedge?
When you buy an option:
- You have the right to exercise at the strike price
- Your maximum loss is defined regardless of how far the market moves against you
- You retain the potential for unlimited (or large) gains in your favor
- The cost is the premium paid upfront
Example: A stockholder buys a protective put. No matter how far the stock falls, the put guarantees a sale at the strike price. The maximum loss is defined.
Think of it this way: Buying an option is like buying insurance. You pay a premium upfront, and in return you get a guaranteed floor (or ceiling) on your losses. Selling an option is like getting a small cash payment in exchange for hoping nothing bad happens; if it does, you are exposed.
Why Does Selling an Option Provide Only a Partial Hedge?
When you sell an option:
- You receive the premium, which offsets some losses
- But the premium is a fixed amount; it does not grow if the market moves sharply against you
- Your losses can still be very large (or unlimited) beyond the premium cushion
- You have an obligation, not a right
Example: A stockholder sells a covered call. The $3 premium provides a $3 cushion, but if the stock drops $20, the net loss is still $17. The hedge is partial.
How Do You Recognize the Pattern in an Exam Scenario?
A scenario may ask which strategy provides the "best protection," "maximum protection," or a "full hedge." The pattern:
- Best protection for a long stock position? → Buy a put (protective put)
- Best protection for a short stock position? → Buy a call
- Best protection for a bondholder against rising rates? → Buy yield-based calls
- Best protection for a U.S. exporter? → Buy currency puts
- Best protection for a U.S. importer? → Buy currency calls
If a scenario asks which strategy provides "income" or is the "least expensive hedge," the answer involves selling an option.
Exam Tip: Gotchas
- Selling an option can never be a full hedge; the premium is finite. If the question asks for "best protection," "maximum protection," or "full hedge," the answer always involves buying an option.
- If the question asks for "income" or "least expensive hedge," the answer involves selling an option.
What Is the Complete Hedging Summary Table?
| Risk | Underlying | Full Hedge | Partial Hedge |
|---|---|---|---|
| Stock decline | Long stock | Buy equity put | Sell equity call |
| Stock rise | Short stock | Buy equity call | Sell equity put |
| Market decline | Stock portfolio | Buy index puts | Sell index calls |
| Rising rates | Long bonds | Buy yield calls | Sell yield puts |
| Currency weakening | Receiving foreign currency | Buy currency puts | Sell currency calls |
| Currency strengthening | Paying foreign currency | Buy currency calls | Sell currency puts |
What Should You Check on Exam Day?
- Can you say, without pausing, that buying an option is always a full hedge and selling one is always a partial hedge?
- If a scenario asks for "best protection," "maximum protection," or a "full hedge," do you immediately think "buy an option"?
- If a scenario asks for "income" or the "least expensive hedge," do you immediately think "sell an option"?
- Can you match each existing position (long stock, short stock, long bonds, receiving foreign currency, paying foreign currency) to its correct full-hedge purchase?