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Protective Call

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Protective Call

Understanding Protective Call

A protective call is an options strategy used by investors who are short a stock and want to limit potential losses. It involves buying a call option on the same stock they have shorted, providing insurance against an adverse price increase. This strategy is similar to a protective put, but instead of protecting a long position, it protects a short position.

How a Protective Call Works

A trader who has short-sold a stock profits if the price declines. However, if the stock price rises unexpectedly, losses can be unlimited. To hedge against this risk, the trader buys a call option at a specific strike price, which allows them to buy back the stock at a predetermined price if the market moves against their position.

Key Components of a Protective Call Strategy

  1. Short Stock Position – The trader initially sells shares they do not own, expecting the price to fall.
  2. Buying a Call Option – The trader purchases a call option at a strike price near or above the current stock price.
  3. Limited Risk, Unlimited Gain – The call option acts as insurance, capping losses while keeping potential gains if the stock declines.

Example of a Protective Call Strategy

  • Short Position: Sell 100 shares of XYZ stock at £50 per share.
  • Call Option Purchased: Buy a call option with a £55 strike price for £2 per contract (100 shares per contract).
  • Possible Outcomes:
    • If XYZ falls to £40, the trader profits £10 per share (excluding the call premium).
    • If XYZ rises to £60, the trader buys back shares at £55 using the call option, capping the loss.

While the protective call strategy limits risk, it has some drawbacks:

  • Premium Costs – Buying a call option reduces overall profit potential.
  • Time Decay (Theta) – Options lose value over time, reducing hedge effectiveness.
  • Strike Price Selection – Choosing the wrong strike price can lead to inefficient hedging.
  • Opportunity Cost – If the stock drops as expected, the call option expires worthless, reducing net gains.

Step-by-Step Guide to Implementing a Protective Call

1. Identify a Short Position

  • Short a stock with high valuation or weak fundamentals.
  • Ensure the stock has liquid options available for hedging.

2. Select an Appropriate Call Option

  • Choose a strike price slightly above the current stock price to minimise costs.
  • Consider the expiration date based on how long you expect to hold the short position.

3. Buy the Call Option

  • Purchase a call option equal to the number of shares shorted.
  • Calculate the total cost and how it affects potential profits.

4. Manage the Trade

  • If the stock declines, hold or close the short position for a profit.
  • If the stock rises, exercise the call option or close the trade before expiration.

Practical and Actionable Advice

To maximise the effectiveness of a protective call strategy:

  • Use It for High-Volatility Stocks – Stocks with potential for large moves benefit most from protection.
  • Consider Option Expiration Carefully – Longer expirations cost more but provide extended coverage.
  • Monitor Trade Regularly – Adjust or close the position if market conditions change.
  • Balance Risk and Reward – Avoid overpaying for a call option that significantly eats into potential profits.

FAQs

What is a protective call strategy?

It is an options strategy where a trader shorts a stock and buys a call option to limit losses if the stock price rises.

Why use a protective call?

It protects against unlimited loss potential in short-selling while allowing for profits if the stock declines.

How does a protective call differ from a protective put?

A protective call hedges a short position, while a protective put protects a long position.

Does a protective call guarantee no losses?

No, but it caps losses at the difference between the short entry price and the call strike price plus the premium paid.

What happens if the stock falls as expected?

The trader profits from the short position, but the call option expires worthless, reducing net gains.

Can I close the call option before expiration?

Yes, if the stock price remains low, you can sell the call before expiration to recover some premium.

How do I choose the right call strike price?

Select a strike price above the short entry price to balance protection and cost.

What is the biggest risk of a protective call?

The call option premium reduces profits, and if the stock moves sideways, the hedge may be unnecessary.

Can I use a protective call on any stock?

Yes, but it works best on liquid stocks with active options markets to ensure reasonable pricing.

Is this strategy suitable for beginners?

It requires understanding short-selling and options, so it’s better for traders with some experience.

Disclaimer: The content on this site is for informational and educational purposes only and does not constitute financial, investment, or legal advice. We disclaim all financial liability for reliance on this content. By using this site, you agree to these terms; if not, do not use it. Sach Capital Limited, trading as Traders MBA, is registered in England and Wales (No. 08869885). Trading CFDs is high-risk; 74%-89% of retail accounts lose money.