Protective Call

[Igor 10]

Traders who implement a protective call strategy are protecting their short sales from surprise market rallies. The protective call acts as an insurance policy from price swings on shares owed. The technique involves short selling assets and purchasing a call option for the amount of shares owned. The protective call limits the investor's loss potential to only the premiums paid when buying the call. Thus, the investor controls their loss, which is set by the terms of the call option. On the contrary, an investor's profit potential is infinite. If the market price crashes, traders who use this strategy can earn substantial gains.

 

Moneyness Review for Calls

 

Out-of-The Money (OTM) = Strike price (more than) Market Price

In-The-Money (ITM) = Strike price (less than) Market Price

At-The-Money (ATM) Strike price (equals) Market Price

 

How to Carry Out A Protective Call Strategy

 

 

Disney stock is worth $50 (market price) in June.

1) Trader short sells 100 shares of Disney stock.

2) Trader buys the call option: DISJul50($2)

- 100 shares of Disney stock

- Strike Price $50, at-the-money (ATM), expiring in 30 days

- Premium Cost of $2

3) Trader pays $200 to enter the market and to protect the short sale. [$200 (paid for call)]

Total cost to enter the market: $200

 

Result one: Disney stock rises (rallies) to $70 in July.

a) The short sale realizes a $2000 loss, and the trader pays $2000.

b) The call option expires ITM.

c) The trader exercises his or her right to buy 100 shares at $50 from whoever sold the call option. The trader pays $5000 to the seller, and receives 100 Disney shares.

d) The trader immediately sells the 100 shares in the open market and receives $7000.

e) The trader loses $200 after adding the cost to enter the market. [$200 = $7000 (share sale) - $5000 (paid for shares) – $2000 (short sale loss) - $200 (cost to enter market)]

 

Result two: Disney stock falls to $30 in July.

a) The short sale realizes a $2000 gain, and the trader receives $2000.

b) The call option purchased expires worthless (OTM).

c) The trader makes a total profit of $1800 after adding the cost to enter the protective call. [$1800 = $2000 (received from short sale) - $200 (paid for protective call)]

 

Result three: Disney stock drops (moderately) to $48 in July.

a) The short sale realizes a $200 gain, and the trader receives $200.

b) The call option purchased expires worthless (OTM).

c) The trader makes a total profit of $0 after adding the cost to enter the protective call. [$0 = $200 (received from short sale) - $200 (paid for protective call)]

 

**Note: In this example, Disney stock at $48 is the breakeven point in this protective call example. Any rally above $48 will result in a loss for the trader. However, the protective call caps the maximum loss at $200.

 

Advantages and Disadvantages in Carrying Out a Protective Call Strategy

 

Pluses: The upside to this type of strategy is that the investor can gain unlimited profits if the call option expires any price below its breakeven point. The protective call also helps investors control losses from sudden market rallies, as they predetermine their maximum loss when they enter the market.

 

Minuses: The downside in using a protective call happens when the market rallies and the investor losses the premiums paid to purchase the call.