Can someone explain hedging with long and short positions in relation to options?

Answer 1

I am assuming

(1) you are asking about hedging stock positions, not other option positions, and

(2) you have a basic understanding of how options work. If you do not, you can go to

http://www.888options.com/

and read the pages under "basics" to learn what options are.

There are any number of ways to hedge stock positions with options, but the simplest is simply to take a bearish options position to hedge a long stock position or to take a bullish options position to hedge a short stock position.

The simplest bearish options position is to simply buy a put option. That is the hedge described in the first answer. You can learn more about that technique at

http://www.888options.com/strategy/protective_put.jsp

The other simple bearish options position is to sell a call options. When you hedge a stock position by selling a call option it is called a covered call. You can learn more about covered calls at

http://www.888options.com/strategy/covered_call.jsp

If you have a short stock position, the simplest hedges are to buy a call option or to sell a put option. Buying a call option hedges a short stock position exactly the same way buying a put hedges a long stock position, and selling a put hedges a short stock position exactly the same way selling a call hedges a long stock position.

In general, selling options is a better hedge if the stock is not very volatile before expiration, while buying options is a better hedge if the stock is more volatile.

One of the slightly more complicated ways to hedge that is fairly popular is a collar. (It is also sometimes called a fence or a hedge wrapper.) You can learn more about a collar at

http://www.888options.com/strategy/collar.jsp

Answer 2

Options give the ability to limit down side- for a price of course.

An example is called a protective put position. Lets say that you own 100 shares of XYZ corp. The shares trade at $50. If you think that there is upside potential, but you are worried about the downside, you can buy (aka take a long position) in a put option on XYZ corp- let's say the strike price is $40. This option gives you the right to sell the shares for $40 anytime prior to expiration.

Now, lets say that the stock price rises to $55. This gives you a return of $5 per share less the cost of the option. If the stock falls to $45, you lose $5 per share along with the cost of the option. If the stock falls to $35, you can exercise the put and sell the shares for $40 and the option writer is obligated to buy the shares. In this case, you lose $10 per share along with the cost of the option. However, this may be less than the $15 that you would have lost without the option. This is the nature of the hedge. It lets you get rid of some of your unwanted risk.

Answer 3

Long position in Options is when you buy a call or put. Short position is when you sell a call or put. Eg; Long call means you have bought call. Short call means you have sold call.
If you have stocks purchased and if you feel that the price is going to go down from the present level, then you can hedge your position by selling calls at that strike price. So if the price goes down you can pocket the premium which is equal to the price lost on the stock. You can also buy put but in this case you have to pay for buying put.
So you can hedge by short calls or long puts.
Hedging is maximising your upside potential minimising the downside risk.
Suppose you have hedged your long stocks with long puts and the market goes down you make up in the options market what you loose in the stock market thus minimising downside risk. Suppose if the price moves up you will loose only the premium for put bought but the stock price rise will adequately compensate for it. This is maximising upside potential.