The protective call is a hedging strategy whereby the trader, who has an existing short position in the underlying security, buys call options to guard against a rise in the price of that security.
Short 100 Underlying, Buy 1 ATM Call
A protective call strategy is usually employed when the trader is still bearish on the underlying but wary of uncertainties in the near term. The call option is thus purchased to protect unrealized gains on the existing short position in the underlying.
Unlimited Profit Potential
The protective call is also known as a synthetic long put as its risk/reward profile is the same that of a long put's. Like the long put strategy, there is no limit to the maximum profit attainable using this strategy.
Unlimited
Profit achieved when: Price of Underlying < Sale Price of Underlying - Premium Paid
Profit = Sale Price of Underlying - Price of Underlying - Premium Paid
Limited Risk
Maximum loss for this strategy is limited and is equal to the premium paid for buying the call option.
Premium Paid + Call Strike Price - Sale Price of Underlying + Commissions Paid
Loss occurs when: Price of Underlying <= Strike Price of Long Put
Breakeven point
Sale Price of Underlying + Premium Paid
Example
An options trader is short 100 shares of XYZ stock trading at $50 in June. He implements a protective call strategy by purchasing a SEP 50 call option trading at $200 to insure his short position against a devastating move to the upside.
Max Loss Capped at $200
Maximum loss occurs when the stock price is $50 or higher at expiration. Even if the stock rallies to $70 on expiration, his max loss is capped at $200. Let's see how this works out.
At $70, his short stock position will suffer a loss of $2000. However, his SEP 50 call will have an intrinsic value of $2000 and can be sold for that amount. Including the initial $200 paid to buy the call option, his net loss will be $2000 - $2000 + $200 = $200.
Unlimited Profit Potential
There is no limit to the profits attainable should the stock price head south. Suppose the stock price crashes to $30, his short position will gain $2000. Excluding the $200 paid for the protective call, his net profit is $1800.
Commissions
These examples exclude commissions and fees. Include all transaction costs when evaluating the profit or loss of a position.