Construction: Short 100 shares of stock, buy one call
Function: To provide upside protection for a short stock position. It’s like an insurance policy on short stock.
Bias: Bearish but cautious.
When to Use: When wishing to limit risk of a short stock position, or to protect profits of short stock position while continuing to retain short position.
Breakeven: Short stock sale price minus call price.
Max Gain: The position continues to make money for all stock prices below the breakeven point. The theoretical maximum gain occurs if the stock price falls to zero. At that point, your profit equals the breakeven price.
Max Loss: If the stock price trades above the breakeven point, losses will be realized. The maximum loss occurs if the stock price reaches the call strike price or higher. The maximum loss equals the difference between the call strike and the breakeven point.
Key Concepts: Because of time decay created by the long call, the position is best used for protection of existing profits on a short stock position. It is also used to initiate a position when a potentially aggressive or explosive downside move in the near future is a good possibility, and you wish to capitalize on that outlook but with insurance against rising stock prices. The Protective Call is the opposing side of the Buy-Write. In other words, the trader who is on the opposite side of the trade from the Protective Call has the Buy-Write. It is philosophically identical to the Protective Put except for anticipation of stock going down.
Example: Short 100 shares of stock at $50. Buy one $55 call for $2. Your breakeven point is $48. If the stock price is above $48 at expiration, you’ll incur losses. The maximum loss occurs at the $55 call strike. At that point, you’ve effectively shorted shares at $48, but can buy them back for $55, so the maximum loss is $7. For all stock prices below $48, you’ll make gains. The maximum profit is $48 and would occur if the stock price falls to zero.