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