The protective call is a hedging strategy whereby the trader, who has an existing short position in the underlying security, buys call options to guard against a rise in the price of that security.
|Protective Call Construction|
|Short 100 Shares|
Buy 1 ATM Call
A protective call strategy is usually employed when the trader is still bearish on the underlying but wary of uncertainties in the near term. The call option is thus purchased to protect unrealized gains on the existing short position in the underlying.
The protective call is also known as a synthetic long put as its risk/reward profile is the same that of a long put's. Like the long put strategy, there is no limit to the maximum profit attainable using this strategy.
The formula for calculating profit is given below:
Maximum loss for this strategy is limited and is equal to the premium paid for buying the call option.
The formula for calculating maximum loss is given below:
The underlier price at which break-even is achieved for the protective call position can be calculated using the following formula.
An options trader is short 100 shares of XYZ stock trading at $50 in June. He implements a protective call strategy by purchasing a SEP 50 call option trading at $200 to insure his short position against a devastating move to the upside.
Maximum loss occurs when the stock price is $50 or higher at expiration. Even if the stock rallies to $70 on expiration, his max loss is capped at $200. Let's see how this works out.
At $70, his short stock position will suffer a loss of $2000. However, his SEP 50 call will have an intrinsic value of $2000 and can be sold for that amount. Including the initial $200 paid to buy the call option, his net loss will be $2000 - $2000 + $200 = $200.
There is no limit to the profits attainable should the stock price head south. Suppose the stock price crashes to $30, his short position will gain $2000. Excluding the $200 paid for the protective call, his net profit is $1800.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
The following strategies are similar to the protective call in that they are also bearish strategies that have unlimited profit potential and limited risk.
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