Buying vs. Selling Options as a Hedge

This final section ties everything together. Throughout this unit, you have seen that some strategies provide full protection while others provide only partial protection. The distinction comes down to one question: Did you buy or sell the option?

Full Hedge vs. Partial Hedge

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)

Hedging by Position Type

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 Buying Provides 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 Selling Provides 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 the Exam Tests This

The exam typically presents a scenario and asks which strategy provides the "best protection," "maximum protection," or is 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 the exam 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.

Complete Hedging Summary