I’ve hard of “hedging” when someone wants to “lock in” a position’s profit, without selling the stock. I was told this is for tax reasons because if you hold the stock over a year you get taxed lower.
But doesn’t that require additional capital? Do I use options?
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Option-ese gets confusing, here’s my try for a five year old.
My stock is up, I want to keep it because I think it might go higher. But if it goes down I will regret not selling it now. So I buy a promise from someone. They promise to buy it at today’s price if I want, even if they can get it cheaper elsewhere. So they’re taking a risk, but I am paying them money to accept that risk. Now if it goes up I still have my stock, though what I paid the other person is lost. If my stock goes down I call in the promise and the other person buys it at today’s price and all I have lost is what I paid them for the promise.
This particular kind of option is a PUT, because I can PUT the stock on that person if I want. If I buy a promise that the person will sell to me at a certain price if I want them I am buying a CALL because I can CALL the stock to me. The person who will later have the option is BUYing the option. The person making the commitment to the purchase regardless of the price they could get elsewhere is SELLing the option. The price you pay for an option is called a PREMIUM.
There are many, colorfully-named ways to combine options to increase your risk and reward in playing the stock market. Mostly that’s gambling, but sometimes it’s part of a rational strategy. Actually, it’s almost always gambling since it’s a short-term thing.
Now you’re ready to do an Iron Strangle Condor or a Married Collard Bear Straddle!
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