Directional Corner - Articles

Put options can be used to profit from falling stock prices but they can also be used to protect a long stock position. When used in this way, a long put acts like an insurance policy for your stock and is called a protective put. The protective put provides the investor maximum downside coverage for a long stock position.

In a similar way, call options can be used to protect short stock positions. If you are short stock and buy a call to protect your upside risk, that is a protective call. The protective call provides the investor maximum upside coverage for a short stock position. So, while many might think that the protective call is the opposite strategy from the protective put, it is, in fact, philosophically identical. Both positions work in the same way. That is, they both provide maximum protection for a directional stock play. The only difference is that the protective put is used to protect a long stock position while the protective call is used to protect a short stock position.

The protective call position received its more commonly used nickname "synthetic put" not from how it is constructed, but from how it acts. This position simulates the behavior patterns of a long put both in risk and reward and profit and loss. In other words, if you are short stock and long a call, those two positions behave as if they were a long put. The position, from the buyer's standpoint, allows for a fully hedged downside play.

Please take special note that this strategy, in the investment world, is called the "synthetic put." We will refer to it as the protective call for educational purposes because of its philosophical and fundamental relationship to the protective put. If you understand the function of the protective put, you will understand the protective call.

For an opportunity for protection, the buyer pays a premium in the form of purchasing a call. The seller, who receives the premium for the sale of the call, is obligated to deliver the stock to the buyer (should the buyer wish to buy the stock) at the strike price by the specified expiration date. A strategically used long call offers maximum protection against substantial loss in the event the stock, which you are short, trades higher.

There are a couple of basic ways to hedge the risk of a short stock position. First, a trader could provide a small upside hedge by selling a put against the short stock, which is often called a Sell-Write since the trader shorts (sells) the stock and then writes (sells) the put. By selling the put, the trader brings in a premium, which acts to offset an equal dollar amount of upside movement in the stock. The sell-write is also called a Covered Put Strategy.

The Covered Put Strategy (Sell-Write) will cover an investor up only as far as the premium he receives from the put sale, whereas the protective call strategy will protect the investor from the breakeven point up to infinity (theoretically) via the purchase of the call.

This strategy's philosophy is different from the covered put (sell-write) strategy in two major ways.

While the covered put (or sell-write) is a premium selling strategy, the protective call (synthetic put) is a premium purchasing strategy; also, the covered put is most effective in a stagnant or decreasing volatility situation while the protective call is more effective in increasing volatility situations.

When an investor sells a stock short, they can either sell the put (sell-write) or buy the call (protective call or synthetic put) to provide a proper hedge. The construction of the protective call position is actually quite simple. You sell the stock short and you buy the call on a one to one ratio meaning one put for every one hundred shares.

Remember, one option contract is worth 100 shares. So, if we have shorted 400 shares of IBM then you would need to purchase exactly four calls.

From a premium standpoint, we must keep in mind that by purchasing an option, we are paying out money as opposed to collecting money. This means that our position must "outperform" the amount of money that we put out, which is the opposite side of what we did in the covered put strategy.

For example, if we were to pay $1 for a call and we shorted the stock against it, we would need to have the stock decrease in price $1 just for us to break even. Unlike the covered put, the protective call strategy has the premiums working against it, thus the stock needs to move more to offset the cost of the call.

This is why long option strategies need more volatility than short option strategies. We talked about the short option strategies needing to be done over a decent period of time (a year or so) in order to take advantage of the odds. Meanwhile, long option strategies like the protective call need relatively quick, aggressive movements in order to maximize profit potential.

We stated that selling options and collecting the premium was the right thing to do 75% -- 82% of the time. If this is true, then buying an option and paying out premiums is only going to be right 18% -- 25% of the time.

Those are not good odds. So, you should stay away from employing this strategy over a long period of time to avoid having the odds fall against you. However, employing a protective call can be extremely effective in the proper situation.

Let's take a look at the risks and rewards of the protective call strategy over three different scenarios.

******BRETT, PLEASE REPLACE THE GRAPH BELOW WITH THE SYNTHETIC PUT GRAPH******

As previously stated, when we short a stock, three potential outcomes exist. The stock can go up, go down, or remain stagnant. Let's hypothesize results across these three scenarios. Say you short the stock for $29 and buy the front month 30 call for $1.

Contemplate the "down" scenario. Let's assume the stock price is $28.50 at expiration. The results are that you have a $0.50 gain from capital appreciation and a $1 loss from the purchase of the call which combined gives us a $0.50 overall loss.

It is important to realize that the down scenario will only produce a positive return if the gain on the short stock is greater than the amount paid for the call. That being the case, you calculate the breakeven point for the protective call strategy by subtracting the price of the call from the sales price of the stock.

In the "down" scenario, subtract the option price of $1 from the stock price of $29 and you get a breakeven of $28. So, until the stock reaches $28, the position will not produce a positive return. Below $28, the position will gain the amount equal to the stock price minus the premium paid for the option.

However, if the stock were to trade down aggressively, say down to $22, you would see a healthy gain of $6. You would have a $7 gain from capital appreciation and a $1 loss from the purchase of the call you used as insurance.

In the "stagnant" scenario, the position will again produce a loss. Since the stock hasn't moved, there will be no capital gain or loss and with the stock at $29 at expiration, the calls are worthless. The position lost $1, the amount you paid for the calls.

In the "up" scenario, the position will again produce a loss. If the stock price were to trade up $1 to $30, then you would have a $1 capital loss.

Further, with the stock at $30, the 30 calls will be worthless, thus you incur a $1 loss because that is what you paid for them. Add that to your capital appreciation loss and your total loss will be $2 with the stock expiring at $30.

However, in the "up" scenario, the protective call will set a cap on your losses. Let's see how that works. We'll set the stock price down to $32. Since you shorted the stock at $29, there will be a capital loss of $3.

The calls, however, are now in the money with the stock above $30. With the stock at $32, the 30 calls are worth $2. You paid $1 for them so you have a $1 profit in the calls.

Combine the call profit ($1) with the capital loss (-$3) and you have an overall loss of $2. The $2 loss is the maximum amount you can lose regardless of how low the stock declines, even if it goes as low as zero. This is what is meant by maximum protection.

In every protective call position it is possible to calculate your anticipated maximum loss. Use the formula: (option strike price + option price) -- the stock sales price.

Maximum Loss = (Strike Price + Option Price) -- Stock Price

For example, suppose you sold a stock short at $30. You bought the front month 32.5 call for $1. Next, assume the stock closes at $32.50 on expiration day.

Your maximum loss calculation would be:

($32.50 +$ 1.00) - $30.00 = $3.50

$32.50 (closing price) minus $30 (sales price) equals a $2.50 capital loss. However, do not forget that with the stock at $32.50, the 32.5 calls will be worthless.

Add the capital loss ($2.50) plus the option loss ($1) together. The total is $3.50, which is your maximum possible loss in that position. This formula will work every time.

Looking at the three hypothesized scenarios, we find that only one scenario, the "down" scenario, can produce a positive return and that's only when the stock decreases more than the amount you paid for the calls.

The other two scenarios produced losses. If the stock is stagnant, you lose the amount you paid for the put. If the stock goes up, you lose again but the loss is limited. It is the limiting of loss that makes the protective call an attractive and useful strategy.

The Protective Call Strategy can be adjusted to address the particular lean that investor/trader has at any particular time. (The term lean describes the investor's perception of the directional strength of the stock.)

At any given time, an investor could feel that a stock may go up or down, a little or a lot, or just stay where it is. The synthetic put is not a position you would put on if you feel that the stock you own was going to consolidate for a while. You would have a loss in the stagnant lean scenario since the short stock position made no gain or loss, but you were out $1 for the purchase of the call.

However, the situation is different in a bearish lean scenario.

A stock that has the potential to rise quickly also has the potential to fall just as quickly. A stock that has substantial potential gain has an equal potential loss. If a stock has broken down through a support level, that stock could see a rapid, sharp, downward move. There may be an opportunity to capitalize on this event by shorting the stock.

An investor choosing to short a stock like this should have more protection to the upside then a covered put can provide and at the same time more allowance for a larger downside potential than the covered put allows.

This is a perfect time to use the protective call (synthetic put) strategy. The purchase of an out-of-the-money call will be a relatively inexpensive investment but will provide the kind of results that will best fit a bearish lean.

You will have maximum upside protection with all the room you need for your stock's potential decline. Of course, this comes at a price. You must pay for the protection and freedom this position can provide.

The protective call can also be used when you have a little bullish lean on your short stock position. Let's say that you shorted a stock that has traded down very nicely. The stock has gotten to a point where you think about possibly buying it back and taking your profits but are afraid to do so because you feel it may still trade down more and you will not forgive yourself for getting out too early.

Instead of buying the stock back and missing out on the continued decline, look into buying a call for protection. It will allow you to continue your capital gains as the stock trades down while limiting your loss to a fixed, known amount.

In cases such as this one, the purchase of an at-the-money or slightly in-the-money call will ensure you get a good purchase price if the stock heads up and allows you ongoing profit if the stock continues down.

Of course, if the stock stays still, you would lose the amount of premium you spent on the call. If the stock continues down, however, it would have to trade lower than the amount you spent on the call before your short stock's downward movement starts to make you money again.

Key Point

The protective call strategy, when used correctly, will allow investors to take advantage of some opportunities that could provide large potential gains without being exposed to the severe risks that normally accompany such risky opportunities. With the proper protection in place, the investor can profit from aggressive downside moves in the stock while having a fixed, limited loss.

As stated before, this strategy is not going to work all the time. However, there are some especially favorable opportunities for implementing the protective call strategy.

One is the case of a stock in the process of a steep incline. Quite often, IPO (initial public offering) stocks trade up wildly on inadequate supply to surreal public demand to absurd levels like many Internet stocks over the late 90s and even today. We have all seen these stocks trade to ridiculously high levels that we all knew could not be maintained.

Everyone knew these stocks were way over valued and knew that they would sell off as radically as they traded up. It seemed like an easy trade to just short stocks of this nature, wait for them to come back down to reality, and cash in on big profits.

Although this scenario sounds good, these types of trades are risky. The risk is in identifying the true top. A stock that is in a rapid incline might give a false indication of a top or exhaustion level, which could lead to substantial losses. The protective call will provide protection against this kind of substantial loss.

A stock that explodes to the upside will finally "exhaust" or works through the buyers. The stock then proceeds up to higher levels where buyers are no longer interested in buying the stock.

At this level, the stock consolidates and sellers move in. Because the buyers are now done (exhausted) the demand is lifted from the stock and it proceeds down as sellers now out-number buyers.

There are models that are used to calculate where this top may lie, commonly referred to as "exhaustion models" and are based largely on volume analysis. The problem is that the stock, on the way up, may stop, consolidate, and give the appearance of exhaustion but then continue further up. If you had shorted the stock at the false appearance of exhaustion, you could be looking at a big loss.

There is a potential for a very big reward if you pick the "right" top. However, with the big potential gain comes the big potential loss that is common in these types of risk/reward scenarios. Here is a perfect opportunity to employ the protective call strategy!

Remember, the protective call allows for a large potential profit with a limited, fixed potential loss. If you feel that the stock has topped out and is starting to trade down, you short the stock and purchase the call.

If you are right, and the stock gaps down, the profit from the short stock position will well exceed the price paid for the call. Once the stock trades back down, consolidates, and develops its new, lower trading range, the need for the protective call is over. At this time, if you still like the short side of the stock and want to hold on to the short position, you could always start selling puts against it and begin a covered put position.

The protection provided by the protective call strategy will save you enough money when you pick a false (wrong) top that you may, if you like, try to pick the top again at a higher point. The buyer exhaustion scenario, as described here, is a perfect opportunity to apply the protective call (synthetic put) strategy.

As seen with the exhaustion example, the protective call strategy is best used in situations where the stock has a potential for an aggressive downside move.

Another potential opportunity for using the protective call is in combination with Technical Analysis. Technical analysis is the study of charts, indicators, oscillators, etc. Charting has proven to be more than reasonably accurate in forecasting future stock movements.

Stocks travel in cycles that can and do form repetitious patterns. These patterns are predictable and detectable by the use of any number of charts, indicators and oscillators.

Although there are many, many forms and styles of technical analysis, they all have several similarities. The one we want to focus on is the technical "break-down." A break-out is described as a movement of the stock where its price trades quickly through and beyond an obvious "technical support."

For a bearish break-down, we are speaking of a level at the very bottom of a stock's present trading range. Once through that level, the stock is considered to have "broken down" of its trading range and will now often trade lower, seeking to establish a new lower trading range.

The "break-down" is normally a rapid, large downward movement that features an expansion in implied volatility and usually offers an outstanding potential return if identified properly and acted upon in a timely fashion. However, if the break-down fails, the stock could trade back up to the top of the previous trading range and implied volatility could contract.

If the break-down should fail, you would incur a large loss because you would have shorted the stock at the lower end of the previous trading range. With the stock, more likely than not, now on its way back to the upper end of the trading range you face a loss. As you can see the "break-down" scenario is an opportunity that has large potential rewards but can on occasion, have a large potential risk.

Therefore, this is an excellent scenario for application of the protective call strategy.

For example, XYZ is presently at the bottom of a trading range with the upper end of the range being $68.00 and the bottom end of the range being $58. When the chart, indicator, or oscillator you are using identifies the break-down of the stock (when it trades below $58.00), you would short the stock immediately.

The risk of the stock not following through with its break-down is not large but it does happen. The stock could trade back up to $68, which is the top of the trading range. If you had shorted the stock naked below $58, you would realize a minimum $10 loss if the stock did indeed trade back up to $68.

However, if you were to apply a protective call strategy with the stock purchase, you can drastically limit your negative exposure. For instance, say you were to buy the 60 strike call for $2. If the stock trades down to $49, you would make $9 if you shorted the stock naked but only make $7 if done with the protective call.

This difference is the cost of the call. This $2 investment is more than worth it should the stock go back up. If the break-down turns out to be a "false" break-down, and the stock reverses and trades up, your 60 call will allow you to buy your stock back at $60 plus the $2 you paid for the call. This limits your loss to $4 instead of a potential $10 loss. Shrewd investors would agree that this is a much better risk-reward scenario.

Conclusion: The protective call (synthetic put) allows the investor the room to be wrong by limiting their total loss thereby increasing the amount of opportunities an investor may capitalize on. Because the loss is limited, the protective call investor has a staying power not afforded to naked short stock players who would feel the full brunt of the loss if wrong.

This ability to play again increases the protective call buyer's chance of being right and therefore more profitable than the naked stock buyer would be. So, if you feel a stock has a good chance of trading down aggressively because it has become over extended or is about to break down, you may want to explore the use of the protective call (synthetic put) strategy.