The example on Page 192 says the indiviual can hedge their short call position with a long stock position. How does this protect against DOWNside risk?
You short the call and collect the call premium at initiation to take the unlimited downside risk if the stock increases in value, you lose equally by that exact same amount (zero sum game) but mind you, you also have long the stock, means you have purchased the stock and kept it in your kitty, just in case, the counterparty LONG CALL position owner decided to exercise the option, you just deliver the stock to him, no need to buy the stock from the market at the prevaling levels. And by doing the SHORT CALL and LONG STOCK combo you are making sure that even if the stock goes to zero (stock is worthless) you lose only the [S - CallPremimumCollected]. Hope I did not confuse you.
Not confusing at all. Got it! Thanks.
I always found that if I have a problem with a derivatives concept like this, drawing (or visualising) a payoff chart always helps.
you lose “only” the stock value minus the call premium… isn’t that an enormous loss in most cases?.. you can buy a put and and then i think you’re payout is guaranteed (strike price), but the cost is the discounted value today. so basically flat.
I think what bigshibu was getting at was that the selling short of the call option doesn’t really protect you that much. whatever that premium you collect from selling the call detracts from your stock loss. If the stock goes to zero you do lose a ton. That big loss is simply offset by what you collected from selling the short call. Obviously it depends on the circumstances but in most cases a total loss on a stock is only minimally offset by selling short a call