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Protective Call

How Does Protective Call work in Options Trading?

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Protective Call - Introduction

While Protective Puts are used to protect profits in a long stock position, Protective Calls are used to protect profits in a short stock position. Protective Call uses call options to hedge short stock positions while preserving profitability if the stock continues to fall.

Without Protective Call, the only way a stock trader can protect unrealised profits on short stock positions is to liquidate (buy back) a part of the holding. However, liquidating part of the holding denies the stock trader access to future profits should the stock continue to fall. Options trading solves this dilemma using Protective Call.

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Protective Call is simple options trading strategy involving the purchase of at the money call options whenever you wish to "lock in" the profits on your short stock position. Once the Protective Call is in place, the call options will appreciate in step with any appreciation in the stock price, hedging against any losses completely.

You pay a premium for insurance even if it is not used, right? That's exactly the same for Protective Call. You pay the premium on the call options exactly as you would pay for an insurance premium. If the price of the underlying stock continues to fall, the call options expire out of the money eventually, incurring the cost of the call options as expense, while still allowing the short stock position to appreciate with the drop in the stock.

Protective Call creates a position known as a synthetic long put in options trading as it transforms the unlimited profit and loss characteristics of the short stock position into an unlimited profit (albeit restricted to the remaining value of the stock) and limited loss position, just like a put option. You could also create the same profit/loss profile as Protective Call using only a fraction of the money involved in the Protective Call by using another options trading strategy known as the Fiduciary Put.

When To Use Protective Call?

You would use Protective Call whenever your short stock position has appreciated to the point where it's profits must be protected while keeping further profitability open.

Protective Call Example :

Assuming you shorted 100 shares of XYZ at $40 on 1 Jan. XYZ falls to $30 within a few days and you wish to hold on for future appreciation without risking a short term pull up.

How To Use Protective Call?

Protective Call is a simple options trading strategy where you simply buy to open 1 contract of at the money call options for every 100 shares that you shorted.

Protective Call Example :

To seal in that $10 appreciate in value, you would buy to open 1 contract (equivalent to 100 shares) of $30 Call Options expiring a few months later (e.g March30Call for $0.80).

Profit Potential of Protective Call :

Protective Call is an options trading hedging strategy which, combined with the underlying short stock position, grants unlimited maximum profit as long as the underlying stock continues to fall.

Profit Calculation of Protective Call :

The cost of the Call Options are expensed against the rise in value of the short stock position when calculating profits.

Profit = (initial stock price - Current stock price - cost of call) x number of shares

Protective Call Example :

Assuming XYZ falls to $20 by the expiration of the March30Call.

Profit = ($30 - $20 - $0.80) x 100 = $920

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Risk / Reward of Protective Call:

Upside Maximum Profit: Unlimited (restricted by value of stock remaining)

Maximum Loss: Limited

Break Even Point of Protective Call:

Because you incur a cost on the call options, the underlying stock needs to fall to cover that cost. The breakeven point is the point beyond which the Protective Call position would continue to profit.

Breakeven = Initial stock price - cost of call options bought.

Protective Call Example :

Breakeven = $30 - $0.80 = $29.20

Advantages Of Protective Call:

  • Allows you to hold on to your short stock position while insuring against any losses.

  • Allows you to quickly transform the position into a Synthetic Straddle options trading position in order to profit from both up and down moves.

    Disadvantages Of Protective Call:

  • Cost of the call options eats into profit margin.

    Alternate Actions for Protective Call Before Expiration :

    1. If the underlying stock continues to fall strongly, one could sell the out of the money call options and then buy at the money call options in order to re-establish the Protective Call position at the lower price.

    2. If the underlying stock rallies strongly, one should continue to hold the Protective Call position all the way to expiration.

    Alternate Actions for Protective Call During Expiration :

    1. During expiration, if the call options are in the money due to a rise in the underlying stock, you could sell the call options on expiration day.

    2. During expiration, if the call options are out of the money due to the underlying stock falling, one should simply let the call options expire worthless rather than incurring costs by selling them.

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