This is a bearish strategy which combines hedging (protection against risk).

Construction

 

 

 

The protective call strategy is like a synthetic long put because it has the same profit/loss diagram and risk profile (see page ”put-call parity” for a better understanding of the mechanism).

When to use

When we already have a short stock position but we also want to protect it from a rising in stock price, without having to close the position.  Preferably implied volatility should be low when we are buying the call, although the main goal of the strategy is protection so we can ignore volatility for our purpose. The long call position of the strategy will partially compensate for any losses occurred from the short stock position. 

Loss/Profit at expiration

Maximum loss: (Long call strike price – price at which we sold short stock) + premium paid + commissions.

Maximum profit: Very high (until the stock goes to zero) – premium paid – commissions.

Profit/Loss diagram

Below we can see the profit/loss diagram for the protective call strategy. We assume that the stock has been sold short at $24.50, the call strike price is $25 and the premium is $1.

Protective call strategy example

In the daily chart of  F (below), price has visited a support zone (between lines 1, 2) for the second time. We expect that a breakdown will take place soon and the stock will keep on falling in the long term. What troubles us is that the market (SPY) hasn’t yet developed a clear downtrend. We can sell short 500 shares at $11.80 (point A) and simultaneously buy 5 calls with strike price $12 and expiration after one month, in order to protect our main position from an upward move.