What is Protective Call Option Trading Strategy?

Options trading involves various permutations and combinations of Call and Put options. Over time, numerous option trading strategies have been developed. A trader may choose the strategy which is best suited to his risk appetite, market perception, and reward expectation. The protective Call Option Strategy is one such widely used trading strategy.

Protective Call Option Strategy

Protective Call Option is a hybrid option strategy involving call options and futures. It involves combining a short position of an underlying asset with purchasing call options. Thus, this protects from price rises against expectations. The primary objective of a protective call strategy is hedging i.e., minimizing the risk involved in a trade.

Consider the following example to better understand the protective call strategy.

Let’s suppose, the current market price for the shares of HDFC Bank is Rs. 1600. A trader believes that the share price of HDFC Bank is overvalued and expects a reduction in prices. Hence, the trader short sells shares of HDFC Bank at Rs. 1600.

To mitigate the risk associated with the naked position, the trader also purchases an at-the-money call option. Hence, he will buy a call option of HDFC Bank at Rs. 1600 for a premium of Rs. 200. The lot size is 100 shares.

At the outset, the cost involved is primarily attributed to the premium paid for the call option which is Rs. 2000. The profit or loss from the strategy will be dependent upon the price movement of the underlying asset.

Scenario 1 – The price of HDFC Bank falls to Rs. 1500

In this case, the price movement is in line with the investor’s expectation. Thus, the profit earned from the future is Rs. 100 (Rs. 1600-1500) per share. The call option will expire worthlessly and the premium paid is a loss for the trader.

Thus, the overall profit from the trade is the difference between the profit from the trade and the premium paid calculated as Rs. 20,000 (Rs. 100 per share for 200 shares) reduced by a premium payment of Rs. 2,000. The net gain from the position is Rs. 18,000.

If the investor executed a naked call option (instead of a protective call), the gain from the trade would be Rs. 18,000.

Scenario 2 – The price of HDFC Bank is unchanged at Rs. 1600

Thus, the profit earned from the future is Rs. 0 (Rs. 1600-1600) per share. The call option will expire worthlessly and the premium paid is a loss for the trader.

Thus, the overall loss from the trade premium paid Rs. 2,000.

If the investor executed a naked call option (instead of a protective call), the investor would neither earn profit nor incur loss from the position.

Scenario 3 – The price of HDFC Bank increases to Rs. 1700

In this case, the price movement is opposite to the investor’s expectation. Thus, the loss incurred in the Future is Rs. 100 (Rs. 1700 – Rs. 1600) per share. On the other hand, the gain from the call option is Rs. 100 (Rs. 1700 – Rs. 1600) per share.

Overall, the net loss from the position is the premium paid of Rs. 2,000.

If the investor executed a naked call option (instead of a protective call), the loss from the trade would be Rs. 20,000.

The execution of a protective call option reduces the risk associated with a naked call trade. It is used by traders to safeguard the profits from open positions.

When should you use Protective Call Option Strategy?

A protective call option is suited for traders with a bearish approach to the underlying market and expect it to fall. However, the trader may be uncertain in the short term. The price may increase temporarily before it falls. As a precaution, a protective call is the best bet against an upward increase in price. The risk associated is mitigated with a protective call. Hence, the protective call is used during times of uncertainty with an expectation of falling prices.

On the contrary, if the investor is certain about a price correction, then a naked call option is better suited.

Risks and Rewards associated with Protective Call

From the above example, the following conclusions are drawn:

1. The Break-even point for a protective call is the difference between the underlying price and the premium paid on the call option. The trader will neither earn a profit nor incur a loss when the price of the underlying is equal to the sale price of the underlying and the premium paid.

2. The risk associated with a protective call is limited. The maximum loss from the position is restricted to the premium paid at the time of purchasing the call option. This occurs when the price movement is in contrast to the trader’s expectation. If the price of the underlying is less than the strike price of the call option then the trade ends in a loss.

3. The potential for reward from a protective call is unlimited. Profit from the trade is a function of the price underlying. the difference between the sale price and the strike price is reduced by the premium paid. Profit is achieved when the price of the underlying is less than its sale price.

4. The risk and reward of a protective call are similar to that of a long put and so it is also known as a synthetic long put.

Frequently Asked Questions

Is the protective call a good strategy?

A protective call has its pros and cons. A protective call hedges the risk of a short position while maintaining an unlimited profit potential. Although, the premium paid for the call option may eat into the profits from the trade. Hence, a protective call is a good strategy provided the objective of the investor is predetermined and in line with the rationale of a protective call option.