Protective Call : Buying Calls & Short Underlying

Introduction To Protective Call

The protective call strategy involves shorting the underlying security while buying call options to hedge against price increases of the underlying security. When a short position on stocks is initiated, the trader believes that the price of the underlying security will decrease to a point where he can choose to close the position with profit. But if it increases instead, the trader stands to make a loss. That is where a protective call strategy comes in.  A trader is generally bearish but wants to protect the value of his investments in case stock prices go up. Hence, he buys call options to hedge against price increases of the underlying security.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited Loss
Step 7 : Loss calculation of a protective call
Step 8 : Profit
Step 9 : Profit calculation of a protective call
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Executing A Protective Call

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Step 1 : Perform economic, fundamental and technical analysis

Conduct some economic analysis, fundamental analysis and technical analysis to have an idea of general market conditions and conditions of the underlying security. The options trader should look  out for chart patterns such as:

Step 2 : Outlook

A trader who executes a protective call strategy is moderately bearish on the underlying security, that is, he predicts that the price of the underlying security will move lower.

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Step 3 :Study the option chain

Be mindful of the current price of the underlying security and study the options chain to select call options to be used.

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Step 4 : Breakeven Analysis

The breakeven price point of the protective call strategy is :

Short sale price of the underlying security + Premium paid for the call

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Step 5: Understand Your Profit Zones

Prior to this step, the trader has already calculated the breakeven point. Ultimately, the trader must able to understand where the profit zones are. As long as the price of the underlying security trades below the breakeven point, the trade is profitable. A representation of the profit zone is shown in the diagram here.

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Step 6 : Limited Loss

The loss in a protective call is limited.

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Step 7 : Loss calculation of a protective call

The maximum loss can be calculated as:

Exercise price of call – Short sale of underlying security + Premiums paid for call(s) + Commissions paid to broker

Just to shed some light on the equation above, since the long call is at the money(the short sale price of the underlying security is equal to the strike price of the call), the loss can also be calculated as :

Premiums paid for call(s) + Commissions paid to broker

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Step 8 : Profit

The profit to the protective call is unlimited. In general, as the price of the underlying security goes down, the greater the probability of profit from the trade. Since it’s risk and reward profile is the same as that of a long put, it is also known as a synthetic long put. A profit is achieved when the short sale price of the underlying security less the premiums paid for the call is greater than than the price of the underlying security.

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Step 9 : Profit calculation of a protective call

The profit can be calculated as:

Short sale price of the underlying security – price of the underlying security – premiums paid

Limited loss

Due to the function of the long call which is to provide a hedge against rising security prices, the potential loss is limited to the premium paid for the call option(s) when the long call is at the money.

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Step 10 : Calculate Risk & Reward Ratio

If the trader is able to calculate an estimated profit at a certain target price, the trader will be able to find out more about the attractiveness of the trade.

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Step 11 : Executing A Protective Call

For every 100 shares of the underlying security shorted, buy an at the money call to hedge against upward price moves of the underlying security.

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With a reasonable amount of profit, the trader can exit the trade entirely. If the price of the underlying security has increased, the trader can choose to close the position on the call and take a profit on the call, and, hold onto the short underlying position for a possible reversal. If the price of the underlying security has decreased, the trader can close the underlying position at a profit and hold onto the call for a profit if a reversal occurs.

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Step 13 : Record Trade In Diary

The trade should be recorded in a diary for analysis, comparison and reflection. Over time, this will help a trader become better.

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Example Of A Protective Call

The price of RRR Corp is trading at \$40. A trader shorts 100 shares of RRR and buys an at the money December 40 call at a price of \$250. When the price of RRR trades at \$50 on expiration of the call, the loss on the shares is:

(\$50 – \$40) x 100 = \$1000

But, the gain on December 40 call is:

\$1000 – \$250= \$750

The net loss is:

\$1000 – \$750 = \$250

As you can see, this loss is limited to the premium paid for the call option.

If the price of RRR trades at \$20 at the call’s expiration, the gain on the shares is:

(\$40 – \$20) x 100 = \$2000

The call option will expire worthless and hence the net gain/profit is:

\$2000 – \$250 = \$1750

Hence, in a protective call strategy, a trader would want the price to go as low as possible as there is unlimited profit potential when that happens.

If the price of RRR trades at \$42.50 one day later after initiating the trade, the loss on the shares is:

(\$42.50 – \$42) x 100 = \$250

But the gain on the call is \$250.

Hence, there is no net gain or loss at \$42.50. \$42.50 is also known as the breakeven price point.