One of the main cons of going short on a stock is the risk of unlimited loss if prices rise unexpectedly. A protective call offers a solution to this issue by hedging your short position with a call option. Protective calls act as a safety net, allowing traders to control risk while staying bearish. Let’s look into what a protective call is, how it works, and its application on a real-market example.
Key takeaways
- The protective call strategy is a method to hedge a short stock position by buying a call option. You create it by purchasing a call option on an underlying stock that you shorted.
- Protective calls provide a safety net against unexpected price increases in the underlying stock.
- This strategy is useful for traders who want to limit their risk while maintaining a bearish outlook to “fix” the unlimited loss potential of a pure short stock position.
What Is the Protective Call Strategy?
To introduce the idea behind the protective call strategy we could say that, as an options trader, there’s a rather good chance you have already heard of the concept of married contracts. You’d normally hear it in the case of a married put (which is essentially a long stock position coupled with a put option to protect your trade in case things go south), but the protective call, or married call, is somewhat less popular. The trade offers a similar protective strategy from the opposite side.
The protective call involves two key components: a short stock position and a long call option. This strategy is particularly useful when you’re short on a stock and worried about potential upward price movements that could result in unlimited losses. By purchasing a call option, you effectively cap your potential losses—if the stock price rises, the call option gains value, offsetting some of your losses on the short position.
Here is how it works:
- Short Position: You sell a stock you don’t own, anticipating a price drop.
- Long Call Option: You buy a call option on the same stock, providing you the right to buy it at a set price, thus protecting against a price rise.
The profit and loss (P&L) profile of a protective call will normally look like this (as you may find on our options screener):
As you can see, your loss is now capped (which is the main reason why you’d go for this strategy), while you can still earn a potentially uncapped profit if the underlying stock’s price goes down. You are basically giving up on a part of your profit from the short operation to limit your losses in a bullish market scenario.
Going back to our premise: when compared to the protective put, protective calls share the core idea of managing risk. Both strategies involve options to limit downside risks—the protective put protects a long position, while the protective call secures a short position.
A Real-Market Example of a Protective Call
Before we go into an example, let us clarify a lexical detail: in our options screener, a protective call is often labeled as a “married call,” and you can pretty much see these terms as synonyms, for our purpose (in reality, a “married call” is a protective call in which your short position is fully covered – i.e. you buy 1 call for each 100 shares you shorted – which may not always be the case).
Now, imagine you’re bearish on the automotive sector and decide to short Ford Motor (F) stock, currently trading at $11.19. You short 100 shares of Ford, anticipating a price decline. However, you’re wary of the inherent risk of unlimited losses if the stock price unexpectedly increases. This is where a protective call can be useful.
Setting Up the Trade
On our options screener, you may find this trade:
This is what you’d do:
- Short 100 Shares of Ford (F): You sell 100 shares you don’t own, betting on a price drop.
- Buy a Call Option: You purchase a $11 call option expiring in a month. This option costs you a small premium but offers the right to buy the stock at $11, capping your potential loss.
Notice, from the P&L above, that you have the typical capped loss on the right while keeping a nice uncapped profit potential on the left.
How the Protective Call Works
If Ford’s price rises above $11, your call option increases in value, offsetting losses from your short position. For instance, if the price climbs to $12, your short position incurs losses, but the gained value from the call option helps reduce these losses.
- Breakeven Point: In this scenario, your breakeven is $10.74, considering the premium paid for the call. If the stock price stays below this level, you profit from the short position.
- Capped Losses: The protective call caps your maximum loss to $26. This is crucial because it limits your risk, unlike a naked short position.
Potential Outcomes
- Stock Price Declines: If Ford drops below $11, you profit from the short sale, with the only reduction being the call’s cost.
- Stock Price Rises: Should the price surpass $11, the call gains value, capping your losses.
Market Considerations
Checking historical prices is always wise:
As you can see from the chart above, Ford has fluctuated between $10 and $11.5, suggesting potential for movement back to $10. This historical range gives context and supports your bearish outlook while understanding the protective call as a safety measure.
Key Benefits
- Risk Management: Limits losses while allowing for profit if the stock falls.
- Peace of Mind: Provides a buffer against unexpected price hikes.
In this example, using a protective call gives you confidence to maintain your bearish stance on Ford, knowing that potential losses are capped. This strategy balances risk and reward, fitting well into a cautious trader’s playbook, especially in volatile markets.
The Pros and Cons of the Protective Call
Having seen the Ford example, it is now easier to understand what the main pros and cons of the protective call strategy are. The table below summarizes the main advantages and disadvantages of the protective call strategy:
Pros
- Downside Protection: One of the most significant advantages of a protective call is that it provides a safety net against unexpected upward price movements. By purchasing a call option, you cap potential losses on your short position, ensuring that even if the stock price surges, your losses are limited.
- Uncapped Profit: You may think that adding an option to your short stock strategy may come with the obligation to cap your profits, but that’s not the protective call case. In fact, with the simple purchase of a call contract, you are just reducing your profit potential, which will still increase linearly if the underlying stock price declines.
Cons
- Cost of Call Option Premium: The primary drawback of using protective calls is the cost associated with buying the call option. This premium can reduce your overall profit potential, especially if the underlying stock does not move significantly in the anticipated direction.
- Unprofitability in Stable Markets: If the stock price remains relatively stable, the protective call strategy may not be profitable. The cost of the call option may outweigh any minor gains from the short position, resulting in a net loss. In the end, in these occasions you may end up thinking that the purchase of a call contract was a useless expense.
What Should You Consider Before Opening a Protective Call?
There are a few additional factors to weigh before opening a protective call. Here is a table summarizing a few common tips for the volatility impact, selecting the right strike price and expiration date:
Volatility Impact
Volatility plays a significant role in option pricing. Generally, after buying a call option, you would benefit from an increase in implied volatility, which boosts the option’s value. However, with protective calls, this impact is neutralized since you hold both long and short positions on the same stock. The call option’s value may rise, but your main focus is on using it for protection rather than speculation. Therefore, you are generally not looking for any particular change in implied volatility when opening a protective call.
Strike and Expiration Selection
This is where things can get tricky. You need to select the right call option strike and expiration date to ensure maximum protection while minimizing the cost of the call option. That’s easier said than done, but here are a few general tips:
- Strike Price: Choosing the correct strike price is vital. It defines the level of protection and the cost you’re willing to bear. A lower strike price offers more immediate protection but comes at a higher premium, affecting your potential profit.
- Expiration Date: Selecting the right expiration date requires balancing between the cost and liquidity. Longer expirations might offer more security but are often less liquid and carry wider bid-ask spreads. If you anticipate significant price movements, shorter expirations might be more flexible.
Other Considerations
- Matching Options to Exposure: Ensure the number of call options aligns with your stock exposure. For example, if you’re short 200 shares, you’d need two call options for complete coverage. Mismatching can leave parts of your position unprotected.
- Liquidity and Market Conditions: Consider the overall market conditions and liquidity of the options you choose. Illiquid options can lead to unfavorable pricing and execution issues.
- Personal Risk Tolerance: Adjust the strategy based on your risk tolerance. If you’re more risk-averse, you might opt for more comprehensive coverage, even if it costs more.
When Is Trading a Protective Call a Good Idea (and When You Should Go for Other Strategies)
We’ve covered pretty much all you need to know about the protective call strategy. However, at this point, you may be left with a question: when is trading a protective call actually a good idea, and when might you want to consider other strategies?
Ideal Scenarios for Employing a Protective Call
A protective call is best suited for traders with bearish expectations for an asset. While it involves a long call option, the strategy itself benefits from a decline in the underlying price.
Comparing with Other Strategies
While protective calls are useful, they aren’t always the best choice. Here’s how they stack up against other strategies:
- Long Puts: If you’re bearish on an asset and want to profit from a price decline, a long put might be appropriate. This strategy involves buying put options in anticipation of the asset’s price falling.
- Naked Calls: For those expecting a drop or stable market with no upward movement, naked calls might be suitable. This strategy involves selling call options without holding the underlying asset, which can be risky if the asset’s price rises.
Key Considerations
- Cost vs. Benefit: Before choosing any strategy, weigh the cost of options versus the protection or income they offer.
- Market Conditions: Assess current market conditions to determine if volatility is likely and how it might impact your strategy choice.
- Risk Tolerance: Understand your own risk tolerance. Protective calls are insurance, so if you’re risk-averse, the cost may be worth the peace of mind.
Ultimately, the decision to use a protective call or another strategy should align with your market outlook and personal risk profile. Each strategy offers unique benefits and drawbacks, so consider these carefully before proceeding.
