Protective Call Explained



The protective call options strategy is a hedging strategy that involves buying call options to guard against a rise in the price of an existing short position which you already own.

Here’s how it’s constructed:

Short 100 Shares – Buy 1 At the Money (ATM) Call Option

You would deploy a protective call strategy if you had a bearish outlook on the underlying stock and were wary of uncertainties in the short term. The call option is purchased to protect unrealized gains on the existing short position in the underlying stock.

Maximum Profit Potential

The beauty of the protective call strategy is that it has an unlimited upside, there’s no limit to the maximum profit attainable using this strategy. Add to that the limited risk and you can see that this strategy has a very high risk reward  ratio.

You can calculate the maximum profit potential of your trade using the formula below:

  • Profit = Sale Price of Underlying – Price of Underlying – Premium Paid

Maximum Loss Potential

The maximum possible loss for this strategy is limited to the premium paid for buying the call option.

You can calculate the maximum potential loss for your trade by using the formula below:

  • Max Loss = Premium Paid + Call Strike Price – Sale Price of Underlying + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Long Put

Breakeven

The underlying price at which breakeven occurs for the protective call position can be calculated using the formula below.

  • Breakeven Point = Sale Price of Underlying + Premium Paid

Protective Call Example

Let’s say you’re already short 100 shares of Google (GOOG) stock trading at $50 in May. You decide to implement a protective call strategy by purchasing an AUG 50 call option trading at $200 to hedge your short position against a damaging move to the upside.

If the stock price is $50 or higher at expiration, even if it rallies to $70 upon expiration, your maximum loss is capped at $200. Because at $70, your short stock position will suffer a loss of $2000, however your AUG 50 call will have an intrinsic value of $2000. Including the initial $200 paid to buy the call option, your net loss will be $2000 – $2000 + $200 = $200.

There’s no limit to the profits attainable should the stock price head south. Suppose the stock price crashes to $30, your short position will gain $2000. Excluding the $200 paid for the protective call, your net profit would be $1800.

Commissions

To make the above example easier to understand we’ve left broker commissions out of the equation. In the real world you’ll have to pay commission for every trade you make, including the initial stock purchase and the call option. If you use a retail broker like optionsXpress these commissions are usually around $10 to $20.

That’s fine if you trade options infrequently, but what if you consistently trade strategies that involve three or more options contracts? Fortunately there are brokers like OptionsHouse that specialize in this kind of strategy. Here you’ll find commissions as low as $0.15 per contract (+$8.95 per trade).

Conclusion

The protective call options strategy is a great strategy for hedging open positions, so it’s perfect for you if you’re managing your own IRA or have a significant stock portfolio.

This is a difficult strategy to practice however since it does require you hold the underlying stock. But since it only requires buying one call option which is used to hedge an open position, you should soon get the hang of it.




Leave a Reply

Your email address will not be published. Required fields are marked *

Copyright 2008 - 2011 - howtotradestocks.org - All Rights Reserved

Discount Stock Brokers | Compare Online Brokers | Penny Stock Brokers | Sitemap | Privacy/Affiliate