Assignment 1 Lecture 4
Protective Call & Covered Call Probelm
Hatem Hassan Zakaria
A. Protective Call Option
Example: A holder of A call option for 1000 units of XYZ, The exercise price is 30$
within 2 months at Premium 2$, This Holder has a Short Position of the same underlying
asset of 1000 units at 30$
Requirement:
1. Calculate the P&L and related Graphs for this investor at each of the Following
prices 20, 25, 28, 30, 35, 40
2. Calculate the percentage of return for this investor and the Motives for opening
those two positions
3. Suppose the short Position of 1000 units was at 40$ and 10$, calculate the P&L
and Percentage of returns Related
Answer
Definition of Protective Call
The protective call is a hedging strategy whereby the trader, who has an existing short
position in the underlying security, buys call options to guard against a rise in the price of
that security.
A protective call strategy is usually employed when the trader is still bearish on the
underlying but wary of uncertainties in the near term. The call option is thus purchased to
protect unrealized gains on the existing short position in the underlying.
Market
Price
P&L on
Short
Position
P&L on
Call Option
Net P&L
Percentage of
Return on Short
Position
Percentage
of Return
on Call
Option
Percentage
of return
on Both
Positions
20
25
28
30
35
40
+10000
+5000
+2000
zero
-5000
-10000
-2000
-2000
-2000
-2000
+3000
+8000
+8000
+3000
zero
-2000
-2000
-2000
33.33%
16.67%
6.67%
zero
-16.67%
-33.33%
-100%
-100%
-100%
-100%
+150%
+400%
+25%
+9.375%
zero
-6.25%
6.25%
6.25%
Maximum Profit = Unlimited
Profit Achieved When Price of Underlying < Sale Price of Underlying - Premium
Paid
Profit = Sale Price of Underlying - Price of Underlying - Premium Paid
Limited Risk
Maximum loss for this strategy is limited and is equal to the premium paid for buying the
call option.
The formula for calculating maximum loss is given below:
Max Loss = Premium Paid + Call Strike Price - Sale Price of Underlying +
Commissions Paid
Max Loss Occurs When Price of Underlying <= Strike Price of Long Put
Breakeven Point(s)
The price at which break-even is achieved for the protective call position can be
calculated using the following formula.
Breakeven Point = Sale Price of Underlying + Premium Paid
Graph
10
Profit & Losse ($)
8
6
4
2
0
-2
-4
20
25
28
30
35
40
Strike Prices
The Motives for an investor to mix between those two Positions will result in the
Following
1. it will reduce the profit when the price goes down (by amount of the premium)
2. it will limit the loss to the amount of the premium if the price goes up because
short Position will lose but Call option will gain m therefor the Loss is hedged
Suppose the Short Position was at 40$
Market
Price
P&L on
Short
Position
P&L on
Call
Option
Net P&L
Percentage of
Return on Short
Position
Percentage
of Return
on Call
Option
Percentage
of return
on Both
Positions
20
25
28
30
35
40
45
60
+20000
+15000
+12000
+10000
+5000
zero
-5000
-20000
-2000
-2000
-2000
-2000
+3000
+8000
+13000
+28000
+18000
+13000
+10000
+8000
+8000
+8000
+8000
+8000
50%
37.5%
30%
25%
12.5%
zero
-12.5%
-50%
-100%
-100%
-100%
-100%
+150%
+400%
+400%
+400%
42.8%
30.95%
23.8%
19%
19%
19%
19%
19%
Profit & Losse ($)
Graph
20
18
16
14
12
10
8
6
4
2
0
20
25
28
30
35
40
45
60
Strike Prices
Suppose the Short Position was at 20$
Market
Price
P&L on
Short
Position
P&L on
Call
Option
Net P&L
Percentage of
Return on Short
Position
Percentage
of Return
on Call
Option
Percentage
of return
on Both
Positions
5
10
20
25
28
30
35
40
45
60
15000
10000
Zero
-5000
-8000
-10000
-15000
-20000
-25000
-40000
-2000
-2000
-2000
-2000
-2000
-2000
+3000
+8000
+13000
+28000
23000
8000
-2000
-7000
-10000
-12000
-12000
-12000
-12000
-12000
115%
50%
zero
-25%
-40%
-50%
-75%
-100%
-125%
-200%
104.54%
-100%
-100%
-100%
-100%
-100%
+150%
+400%
+400%
+400%
13.63%
36.36%
-9.09%
-31.81%
-45.45%
-54.54%
-54.54%
-54.54%
-54.54%
-54.54%
4
Profit & Losse ($)
Graph
25
20
15
10
5
0
-5
-10
-15
5
10
20
25
28
30
35
40
Strike Prices
B. Covered Call Option
Example: A Writer of A call option for 1000 units of XYZ, The exercise price is 30$
within 2 months at Premium 2$, This Holder has a Long Position of the same underlying
asset of 1000 units at 30$
Requirement:
4. Calculate the P&L and related Graphs for this investor at each of the Following
prices 20, 25, 28, 30, 35, 40
5. Calculate the percentage of return for this investor and the Motives for opening
those two positions
6. Suppose the short Position of 1000 units was at 40$ and 10$, calculate the P&L
and Percentage of returns Related
Answer
Definition of Covered Call
An options strategy whereby an investor holds a long position in an asset and writes
(sells) call options on that same asset in an attempt to generate increased income from the
asset. This is often employed when an investor has a short-term neutral view on the asset
and for this reason hold the asset long and simultaneously have a short position via the
option to generate income from the option premium.
This is also known as a "buy-write".
Market
P&L on Long
P&L on Call Option
Net P&L
Price
Position
20
25
28
30
35
40
-10000
-5000
-2000
Zero
+5000
+10000
+2000
+2000
+2000
+2000
-3000
-8000
-8000
-3000
Zero
+2000
+2000
+2000
Graph
4
Profit & Losse ($)
2
0
-2
-4
-6
-8
-10
20
25
28
30
35
40
Strike Prices
Covered Call Advantages
Selling covered call options can help offset downside risk or add to upside return, but it
also means you trade the cash you get today from the option premium for any upside
gains beyond $32 per share over the next two-months, including $2 in premiums. In other
words, if the stock ends above $32, then you come out worse than if you had simply held
the stock. However, if the stock ends the two-month period anywhere below $32 per
share, then you come out ahead of where you would've been if you hadn't sold the
covered call.
Covered Call Risks
As long as you have the short option position, you have to hold onto the shares, otherwise
you will be holding a naked call, which has theoretically unlimited loss potential should
the stock rise. Therefore, if you want to sell your shares before expiration, you must buy
back the option position, which will cost you extra money and some of your profit.
Limited Profit Potential
In addition to the premium received for writing the call, the OTM covered call strategy's
profit also includes a paper gain if the underlying stock price rises, up to the strike price
of the call option sold.
The formula for calculating maximum profit is given below:
Max Profit = Premium Received - Purchase Price of Underlying + Strike Price of
Short Call - Commissions Paid
Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
6
Unlimited Loss Potential
Potential losses for this strategy can be very large and occurs when the price of the
underlying security falls. However, this risk is no different from that which the typical
stockowner is exposed to. In fact, the covered call writer's loss is cushioned slightly by
the premiums received for writing the calls.
The formula for calculating loss is given below:
Maximum Loss = Unlimited
Loss Occurs When Price of Underlying < Purchase Price of Underlying Premium Received
Loss = Purchase Price of Underlying - Price of Underlying - Max Profit +
Commissions Paid
Breakeven Point(s)
The price at which break-even is achieved for the covered call (otm) position can be
calculated using the following formula.
Breakeven Point = Purchase Price of Underlying - Premium Received
Suppose the Long Position was at 40$
Market
Price
P&L on Long
Position
P&L on Call Option
Net P&L
20
25
28
30
35
40
60
-20000
-15000
-12000
-10000
-5000
Zero
+20000
+2000
+2000
+2000
+2000
-3000
-8000
-28000
-18000
-13000
-10000
-8000
-8000
-8000
-8000
Profit & Losse ($)
Graph
0
-2
-4
-6
-8
-10
-12
-14
-16
-18
-20
20
25
28
30
35
40
Strike Prices
Suppose the Long Position was at 20$
Market
Price
10
P&L on Long
Position
Zero
P&L on Call Option
Net P&L
-2000
-2000
20
25
28
30
35
40
10000
15000
18000
20000
25000
30000
+2000
+2000
+2000
+2000
-3000
-8000
12000
17000
20000
22000
22000
22000
Graph
25
Profit & Losse ($)
20
15
10
5
0
-5
10
20
25
28
30
35
40
Strike Prices
