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Hedging with an Option

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You own a position in the Common Stock of XYZ Pharma Corp. Sometime in the next three months XYZ will announce trial results for a highly-publicized blockbuster new drug. There is no good intelligence on the upcoming news. You expect that the stock price reaction to the news could be substantial - but equally large in either direction, up or down. You would like to protect your downside in XYZ, while preserving the potential upside.

a. Briefly explain how you would hedge with a single option contract.
b. Diagram the payoff of stock + option combination.

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Solution Summary

Hedging strategy to protect a position in underlying stock has been identified. Complete step-by-step explanation including diagram is attached.

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