Question

Covered Call or Protective Put

Suppose that you wish to buy stock and protect yourself against a downside movement in its price. You consider both writing a covered call and buying a protective put.

Briefly explain the differences between these two positions. What gains can you achieve from these positions? What are the costs you have to pay to have those gains?

What factors would affect your decision?

Answer 1

Writing a Covered Call:

When the investor expects that there will not be much movement in the stock price (either in upward or in downward direction),he uses this strategy.

Under this strategy, the investor writes (sells) call option on the same stock that he holds. This generates some income for the investor as option premium. If the stock price goes down, he earns the full premium. If stock price goes up, he loses on the option but the loss is compensated by gain in stock holding

. When the investor expects that there may be downward movement in the stock price, he uses this strategy to protect against loss in stockholding. The investor buys put option on the same stock that he holds. This strategy acts like insurance. This strategy costs the investor a small sum as option premium ,but protects against loss.

If stock price goes down, there will be loss in stock value , but it will be compensated by gainin put option.

Example:

Covered Call:

Current price of stock=$50

Call option premium at strike price of $50 = $1

Write one Call Option at strike price of $50

Amount Received =$1

Protective Put:

Current price of stock=$50

Put option premium at strike price of $50 = $1

Buy one Put Option at strike price of $50

Amount paid =$1

Net Profit of both strategies are given below at different price at expiration.

	A	B	C	D=A+B+$1	A+C-$1
Price at expiration	Gain/(Loss) in stockholding	Payoff Covered call(Write Call)	Payoff in protective Put(Buy Putl)	Net Profit in Covered call(Write Call)	Net Profit in protective Put(Buy Putl)
$45	($5)	$0	$5	($4)	($1)
$46	($4)	$0	$4	($3)	($1)
$47	($3)	$0	$3	($2)	($1)
$48	($2)	$0	$2	($1)	($1)
$49	($1)	$0	$1	$0	($1)
$50	$0	$0	$0	$1	($1)
$51	$1	($1)	$0	$1	$0
$52	$2	($2)	$0	$1	$1
$53	$3	($3)	$0	$1	$2
$54	$4	($4)	$0	$1	$3
$55	$5	($5)	$0	$1	$4