A Protective Call is a strategy wherein, the investor enters a short position in the underlying stock and simultaneously purchases call options of the same underlying to limit the risk of the short sale to a fixed amount.
The name ‘Protective’ itself suggests that this strategy is used as a hedging tactic for short positions.
This strategy is also known as ‘Synthetic Long Put’
When to use this strategy?
This strategy is used when the investor wants to hedge his/her short positions against adverse price movements.
How to build this strategy?
This strategy has two legs:
Leg 1 – Short the underlying security, quantity being equivalent to the lot size of the option contract.
Leg 2 – Buy 1 ATM Call
The since it is difficult to short the underlying security itself, the investor can choose to sell a futures contract of the same underlying and same expiry as the option contract, or use Synthetic Short Stock strategy as a substitute.
Credit Spread/Debit Spread
This is a Debit Spread Strategy.
This strategy is merely a hedge for short positions, hence the profit potential is unlimited.
When is this strategy profitable?
The investor makes profit when the price of the underlying security is lesser than sale price of the underlying security (Future).
This strategy is used as a hedge, hence the risk is limited in this strategy.
When is this strategy unprofitable?
The investor faces losses when the price of the underlying security is lesser than the strike price of the put option purchased.