Overview
A protective call is also known as synthetic long put. It is a trading strategy that is used to manage risks. It is the opposite of a synthetic call. In this an investor first sells a stock and then buys a call option. If the stock prices go up, the call option acts as a safety measure.
This strategy is used by investors because they gain profit if the stock price falls. However, if the price unexpectedly rises, the call option helps limit the losses. The profit comes from the short stock position. The call option on the other hand protects against the sudden price changes.
How It Works?
- An investor short sells a stock.
- They purchase an option to buy at the prevailing market price (ATM) or a bit higher (OTM).
- If the price of the stock falls, they earn a profit on the short position.
- If the price of the stock increases, the call option caps their loss.
Benefits of a Protective Call
- Risk Control: The call option guards against significant losses due to sudden stock price rises.
- Profit Potential: When the price of the stock decreases, the investor benefits from the short position.
- Cost-Effective: In contrast to purchasing a put option, there is no initial premium outlay.
When to Use a Protective Call?
This is a strategy to employ when an investor expects the price of the stock to decline but would like to be safe if it unexpectedly rises.
Conclusion
A protective call is a very helpful strategy that can help investors manage risk while they short-sell a stock. This strategy is ideal for those investors who are expecting that a stock will decline but want protection in case it does not.