SystemTrader
OptionsIntermediateHedging

Protective Call Strategy

Hedge short stock positions by buying call options. The bearish counterpart to protective puts, capping upside risk while maintaining downside profit potential.

Position
Short Stock + Long Call
Outlook
Bearish
Max Profit
S₀ - D
Max Loss
K - S₀ + D

Overview

The protective call (also called "married call") is the hedging strategy for short sellers. You short 100 shares of stock and purchase a call option to protect against upside risk. The call acts as insurance—you pay a premium for the right to buy at the strike price if the stock rises.

This strategy is ideal when you are bearish but want protection against adverse moves. You maintain significant downside profit potential while capping your maximum loss. If the stock rallies sharply, your call option limits losses instead of facing unlimited risk.

The protective call has the same payoff profile as a synthetic long put at the same strike. This equivalence (put-call parity) means shorting stock plus buying a call equals buying a put plus cash. The strategy is popular when regulations or borrow costs make puts expensive, or when shorting with insurance is preferred over outright put purchases.

Key Insight

Upside Protection
Maximum loss is capped at strike
Bearish Profit
Profit as stock falls to zero

Protective Call Payoff at Expiration

This diagram shows the profit/loss at expiration for different stock prices.Profit as stock falls, loss is capped if stock rises.

Entry Price (S₀)
$100
Short 100 shares
Strike Price (K)
$105
Buy 1 call @ $3 premium
Breakeven (S*)
$97
S₀ - Premium = $100 - $3
Max Profit: $97
If stock falls to $0
Max Loss: -$8
Protected above strike ($105)
Protective call payoff
Profit zone (stock falls)
Loss zone (capped)

Research

Research on protective calls, synthetic positions, short selling hedging, and put-call parity.

The Mathematics

In Plain English

The math behind this strategy is straightforward. Here's what you're actually doing:

  1. 1
    Short 100 shares of stock at the current price (S₀)
  2. 2
    Buy 1 call option with strike price K ≥ S₀, paying premium D
  3. 3
    At expiration, if stock is below strike K: call expires worthless, keep short gains
  4. 4
    At expiration, if stock is above strike K: exercise call, buy at K, loss is capped
  5. 5
    Breakeven price = Original stock price minus premium paid

That's it. The formulas below just express this process precisely.

Technical Formulas

1
Profit at Expiration

Formula
P&L = S_0 - S_T + max(S_T - K, 0) - D

Where S_T is stock price at expiration, S_0 is initial price, K is strike, D is premium paid

2
Simplified Form

Formula
P&L = S_0 - K + max(K - S_T, 0) - D

Equivalent to long put payoff (synthetic put)

3
Breakeven Price

Formula
S_* = S_0 - D

Stock must fall by the premium amount to break even

4
Maximum Profit

Formula
P_max = S_0 - D

Achieved when stock falls to zero (limited by premium paid)

5
Maximum Loss

Formula
L_max = K - S_0 + D

Capped at difference between strike and entry, plus premium paid

Strategy Rules

Entry Rules

  1. 1Short 100 shares of the underlying stock (ensure shares are borrowable)
  2. 2Buy 1 call option per 100 shares shorted
  3. 3Choose strike price based on protection level needed (ATM or OTM)
  4. 4Select expiration based on protection timeframe (30-90 days typical)
  5. 5Consider cost of protection vs. potential rally risk being hedged

Exit Rules

  1. 1If stock < strike at expiration: call expires worthless, close short or hold
  2. 2If stock > strike at expiration: exercise call to buy at K, closing the short
  3. 3Can sell call early if stock falls and protection no longer needed
  4. 4Roll to later expiration to maintain continuous protection
  5. 5Close entire position (cover short, sell call) if thesis changes

Strike Selection

  1. At-the-money (ATM): Maximum protection, highest cost (~2-5% of stock price)
  2. Out-of-the-money (OTM): Cheaper protection, accept more upside before hedge kicks in
  3. 5-10% OTM: Common choice balancing cost and protection
  4. Deep OTM: Catastrophic insurance only, minimal cost

Short Selling Considerations

  1. Verify share availability and borrow costs before initiating
  2. Monitor hard-to-borrow status—rates can spike unexpectedly
  3. Account for dividend payments you owe on shorted shares
  4. Understand recall risk if shares become hard to borrow

Implementation Guide

Implementing a protective call requires a margin account with short selling privileges. The key challenge is balancing protection cost against the borrow rate and other short selling costs.

1

Verify Short Availability

Before planning the trade, confirm the stock is available to borrow at a reasonable rate. Hard-to-borrow stocks can have annualized borrow costs exceeding 20%, significantly impacting the economics.

Tips
  • Check your broker's borrow rates (usually shown before shorting)
  • Easy-to-borrow (ETB) stocks have minimal borrow costs
  • Hard-to-borrow (HTB) stocks may make protective calls uneconomical
2

Determine Protection Needs

Decide why you need protection and for how long. Is this for a specific event (earnings, FDA decision) or ongoing insurance? The purpose determines strike selection and expiration.

Tips
  • Event-based protection: Short-dated options around the specific event
  • Ongoing insurance: Roll monthly or quarterly calls
  • Consider how much upside you can tolerate before protection starts
3

Calculate Total Position Cost

Add up all costs: call premium, borrow fees, and any dividends during the hold period. Compare this to a synthetic position (buying puts directly) to see which is more efficient.

Tips
  • Total cost = Call premium + (Borrow rate × Days/365 × Stock price) + Dividends
  • Compare to equivalent put price for same strike/expiration
  • If put is cheaper, consider buying put instead of protective call

Borrow costs can change unexpectedly. A stock that becomes hard-to-borrow can significantly increase your cost basis.

4

Execute the Trade

Short the stock first (or use existing short position), then buy the call. Some brokers offer combined orders. Use limit orders between bid and ask for the call.

Tips
  • Short stock first, then buy call protection
  • Use limit orders for the call, not market orders
  • Check open interest and volume for liquidity
5

Monitor and Manage

Track your protected position including borrow status. If the stock falls significantly, consider selling the call to recapture premium. Watch for corporate actions and dividend dates.

Tips
  • Set alerts at key price levels (strike, breakeven)
  • Consider selling call if it drops to 20% of purchase price
  • Roll before expiration if continuing protection is needed
  • Monitor for hard-to-borrow status changes

Helpful Tools & Resources

Brokers
Interactive Brokers, TD Ameritrade, Fidelity, Schwab
Borrow Analysis
Interactive Brokers SLB, Questrade Borrow Rates
Analysis
OptionStrat, Options Profit Calculator, ThinkorSwim

Strategy Variations

Explore different ways to implement this strategy, each with its own trade-offs and benefits.

Collar on Short Stock

Add a cash-secured put below the current price to offset the call cost. This caps downside profit but creates a "zero-cost" or low-cost protection zone.

The short equivalent of a traditional collar

Synthetic Long Put

The protective call is mathematically equivalent to buying a put at the same strike. Choose based on which is cheaper after considering borrow costs and bid-ask spreads.

Put-call parity ensures equivalent payoffs

Call Spread Hedge

Instead of buying a single call, buy a call spread (buy lower strike, sell higher strike). Cheaper but caps the protection at the higher strike.

Good when extreme rally protection is not needed

Rolling Protection

Continuously roll protective calls before expiration. Provides ongoing insurance but accumulates significant cost over time.

Consider position sizing reduction as an alternative

Consider combining multiple variations or testing them against your specific investment goals and risk tolerance.

Risks & Limitations

High(2)
Medium(2)
Low(1)
Cost DragHigh

Call premium plus borrow costs can significantly erode profits. If the stock stays flat or falls slowly, these costs may exceed the trading gains.

Impact:
Borrow RiskHigh

Shares can be recalled by lenders, forcing you to cover at inopportune times. Borrow rates can also spike, dramatically increasing costs.

Impact:
Dividend RiskMedium

You must pay any dividends on shorted shares. Large special dividends can cause significant unexpected costs.

Impact:
Timing MismatchMedium

If the stock rallies after your call expires or before you buy, you get no protection. Perfect timing is nearly impossible.

Impact:
Opportunity CostLow

Capital tied up in short margin requirements and call premiums could be deployed elsewhere. The strategy requires significant capital commitment.

Impact:
Understanding these risks is essential for proper position sizing and portfolio construction. Consider combining with other strategies to mitigate individual risk factors.

References

  • Israelov, R. (2017). Pathetic Protection: The Elusive Benefits of Protective Puts. Journal of Alternative Investments, 20(1), 16-27 [Link]
  • Israelov, R. & Nze Ndong, D. (2023). Equity Tail Protection Strategies Before, During, and After COVID. SSRN Working Paper [Link]
  • Atmaz, A. & Basak, S. (2017). Option Prices and Costly Short-Selling. Review of Financial Studies [Link]

Options trading involves significant risk and is not appropriate for all investors. Short selling involves unlimited risk if the stock rises. Protective calls have costs that reduce returns over time. Before trading options, read the Characteristics and Risks of Standardized Options document. Past performance does not guarantee future results.

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