8.3 Hedging: Covered Calls & Protective Puts
Hedging blends stock ownership with options. Covered calls generate income at the cost of capping upside, while protective puts establish an absolute price floor.
Key FINRA Exam Takeaways
- Covered Call: Long Stock + Short Call. Primary objective: Generate income on neutral/mildly bullish stock.
- Covered Call Breakeven = Stock Purchase Price - Call Premium received.
- Covered Call Max Gain = Strike Price - Stock Cost + Call Premium.
- Protective Put: Long Stock + Long Put. Primary objective: Full downside protection (portfolio insurance).
- Protective Put Breakeven = Stock Purchase Price + Put Premium paid.
Covered Call Cash Flows and Protection Limits
Writing a call against owned stock cushions downside only by the amount of premium collected. If stock plummets to $0, the investor still loses the entire stock cost minus the premium.
Protective Put (Synthetic Call)
An investor owns stock at $50 and buys a 45 Put for $3. No matter how low the stock plunges, they can exercise the put to sell at $45. Maximum loss is capped at $5 ($50 - $45) + $3 premium = $8.00 per share.
Covered Call Breakeven & Maximum Profit
An investor buys 100 shares of XYZ at $48 and sells 1 XYZ Oct 50 Call at 3.
- Step 1: Breakeven = Stock Cost ($48) - Premium ($3) = $45.00.
- Step 2: Max Gain occurs at or above $50 strike = ($50 - $48 stock gain) + $3 premium = $5.00 per share ($500).
- Step 3: Max Loss = Breakeven ($45) down to zero = $45.00 per share ($4,500).
An investor owns 100 shares of TechCorp purchased at $62 per share. To hedge against potential market drops without selling the stock, the investor buys a TechCorp 60 Put for a premium of $3.50. What is the investor's breakeven price and maximum risk per share?