Can anyone pls explain the concept of protective put n covered call? How protective put graph comes like that by longing a stock n a put and also the graph of covered call, how the break even values r calculated? Is covered call only beneficial for the seller party who knows stock price is not going to rise very soon? If so then why will the buyer buy any covered call?
A bit tough to explain it without the graph and not in person but ill do my best
For the protective put:
lets say you purchase a stock trading at $10. it is clear that this can be represented by a diagonal line. so if the stock went up a dollar you would obviously profit a dollar and if it went down a dollar you would obviously have lost a dollar. so the protective put is basically a way to hedge the loss. So to hedge the loss on being long an asset (the stock) you would purchase a long put. this would negate the effect of the stock decreasing. basically if the stock were to decrease you would lose money on the stock but would make money on the long put option which offsets the losses. there is a great graph in the CFAI reading 58 Exhibit 13. Now in real life, if im not mistaken options consist of 100 shares per option. however for simplicity we can say that one option = 1 share. Of course when you purchase a long put or long call you must pay a premium for being given this right so for the option to break even in the case of a long put the price of the underlying would have to DECREASE by the amount paid for the long put (the premium) assuming the strike price = the underlying price at purchase. or the undetlying would have to increase by the amount paid for the premium.
For the covered call:
in this case you would SELL a call option and buy the underlying asset long. By selling the call you receive the premium which is automatic profit. and in this scenario you will keep this profit if the stock increases because the profit from the stock and the loss from the sale of option would cancel out(this would mean the buyer of the option is in the money so they would exercise). therefore you would basically profit the premium of the option if the underlying value goes up. Now if the price decreases you would lose money if the price of the underlying decreases more then what you made off the premium. The last part of your question is a bit strangely worded. One cannot buy a covered call. Covered call is a strategy that can be used.
To calculate breakeven what i would do is look at the underlying as well as the option separetly first to figure out the breakeven. Just thing of this concept on a very basic and simple basis and it is pretty simple to calculate the break evens.
Hope this helped somewhat. sorry its a bit though to explain when not in person and without graphs
For a start, how about being courteous enough to spell out the words?
You’re asking for help, after all.
Firstly, I thank u for giving so much of ur time…I think I can understand protective put n it seems almost same as purchasing a normal put, am I correct? If there’s any difference, I’m not getting it still.
For covered call, I’m complicating it as always n m gonna ask very silly questions n u’ll know what my level of understanding regarding this is-
If I purchase a stock n sell a call option, the one who’s purchasing it, isn’t he purchasing a covered call or I guess he’s only purchasing a long call. In that case he gives a premium n has the right to purchase the stock at X n if stock price rises to S, he’ll exercise n get a profit of S-X. And my profit is the premium n no loss or is there any loss from the difference between the price at which I bought the stock, S0 and X, when X
And when stock price is declining, nobody will exercise the option n my profit will be the premium until stock price goes below S-premium which is the break even. Is it okay? when I see problems from here, I somehow cannot think clearly at all.
Rianaria
Covered call - if call is in the money then position gain is a difference between purchasing stock price and selling stock price which is exact call option strike (exercise) price + premium.
So gain is limited to difference between purchasing and (selling price + premium).
Protective put - opposite , if put option is realized than loss is a difference between purchasing stock price and
selling stock price which is exact put option strike (exercise) price - premium.
So loss is limited to difference between purchasing and (selling price - premium).
Those are sterile positions because gain/losses are limited, in covered call gain is limited, in protective put loss is limited.
short call + long asset = covered call ( equivalent a short put)
When the price goes up the short call loses value, the long asset gains value, ( total = no change)
When it goes down the short call does not lose or gain, but the long asset loses value. ( total = loss)
The reason why the owner of the asset sells a call is because she feels neutral and can earn a premium (advantage)
If the price stays the same as she expects it will she gains the income from the short call, and still owns the asset
If the price goes down she loses like she would have anyway, but with a little more income from the premium
If the price goes up however she does not share in the upside ( disadvantage)
Why does anyone buy the call when she has written the call? because the other party has a different view. You buy a call when you think that the share price of the underlying will increase.
Arbitrgr
What is strangle, straddle? Could you explain a parallel with cov.call and protective put if exists?
In what situations is preferred to use those strategies?
Many thanks!
Thank you so much Flashback and Arbitrgr…it seems clear, previously whenever I studied these topics, it seemed clear as well, but somehow in the mock exams I get confused every time. I will see if I can answer correctly now…
Good luck guys!
Long call + Long put = straddle
the exercise price has to be the same though
it looks like a V
if the price goes up the holder of the straddle benefits
if the price goes down the holder of the straddle benefits
because the holder is long, and has an option, she pays the call premium and the put premium
this should prove to be quite expensive
To reduce the cost of this position
she can enter into:
Long call + Long put = strangle
the exercise price of the put comes first and then the exercise price of the call
it looks like a V but with a bottom section, almost like a vase.
If the price is less than X1 she makes money
if the price is more than X2 she makes money
but if the price is between X1 and X2 no money is made
this is the difference between the straddle and the strangle
I’m describing the payoff above, not the profit.
“She makes money”
Thanks for clarifying. Once I will play with those positions.