Protective Call Explained

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Contents

Call Provision

What Is a Call Provision?

A call provision is a stipulation on the contract for a bond—or other fixed-income instruments—that allows the issuer to repurchase and retire the debt security.

Call provision triggering events include the underlying asset reaching a preset price and a specified anniversary or other date being reached. The bond indenture will detail the events that can trigger the calling of the investment. An indenture is a legal contract between the issuer and the bondholder.

If the bond is called, investors are paid any accrued interest defined within the provision up to the date of recall. The investor will also receive the return of their invested principal. Also, some debt securities have a freely-callable provision. This option allows them to be called at any time.

Key Takeaways

  • A call provision is a provision on a bond or other fixed-income instrument that allows the issuer to repurchase and retire its bonds.
  • The call provision can be triggered by a preset price and can have a specified period in which the issuer can call the bond.
  • Bonds with a call provision pay investors a higher interest rate than a noncallable bond.
  • A call provision helps companies to refinance their debt at a lower interest rate.

A Brief Overview of Bonds

Companies issue bonds to raise capital for financing their operations, such as purchasing equipment or launching a new product or service. They may also float a new issue to retire older callable bonds if the current market interest rate is more favorable When an investor buys a bond—also known as debt security—they are lending the business funds, much like a bank lends money.

An investor purchases a bond for its face value, known as the par value. This price is most often in increments of $100 or $1000. However, since the bondholder may resell the debt on the secondary market the price paid may be higher or lower than the face value.

In return, the company pays the bondholder an interest rate—known as the coupon rate—over the life of the bond. The bondholder receives regular coupon payments. Some bonds offer annual returns, while others may give semiannual, quarterly, or even monthly returns to the investor. At maturity, the company pays back the original amount invested called the principal.

The Difference With Callable Bonds

Just like the note on a new car, a corporate bond is a debt that must be repaid to bondholders—the lender—by a specific date—the maturity. However, with a call provision added to the bond, the corporation can pay the debt off early—known as redemption. Also, just like with your car loan, by paying the debt off early corporations avoid additional interest—or coupon—payments. In other words, the call provision provides the company flexibility to pay off debt early.

A call provision is outlined within the bond indenture. The indenture outlines the features of the bond including the maturity date, interest rate, and details of any applicable call provision and its triggering events.

A callable bond is essentially a bond with an embedded call option attached to it. Similar to its options contract cousin, this bond option gives the issuer the right—but not the obligation—to exercise the claim. The company can buy back the bond based on the terms of the agreement. The indenture will define if calls can redeem only a portion of the bonds associated with an issue or the entire issue. When redeeming only a portion of the issue, bondholders are chosen through a random selection process.

Call Provision Benefits for the Issuer

When a bond is called, it usually benefits the issuer more than it does the investor. Typically, call provisions on bonds are exercised by the issuer when overall market interest rates have fallen. In a falling rate environment, the issuer can call back the debt and reissue it at a lower coupon payment rate. In other words, the company can refinance its debt when interest rates fall below the rate being paid on the callable bond.

If overall interest rates have not fallen, or market rates are climbing, the corporation has no obligation to exercise the provision. Instead, the company continues to make interest payments on the bond. Also, if interest rates have risen significantly, the issuer is benefiting from the lower interest rate associated with the bond. Bondholders may sell the debt security on the secondary market but will receive less than face value due to its payment of lower coupon interest.

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Call Provision Benefits and Risks for Investors

An investor buying a bond creates a long-term source of interest income through regular coupon payments. However, since the bond is callable—within the agreement’s terms—the investor will lose the long-term interest income if the provision is exercised. Although the investor does not lose any of the principal originally invested, future interest payments associated are no longer due.

Investors may also face reinvestment risk with callable bonds. Should the corporation call and return the principal the investor must reinvest the funds in another bond. When the current interest rates have fallen, they are unlikely to find another, equal investment paying the higher rate of the older, called, debt.

Investors are aware of reinvestment risk and, as a result, demand higher coupon interest rates for callable bonds than those without a call provision. The higher rates help compensate investors for reinvestment risk. So, in a rate environment with falling market rates, the investor must weigh if the higher rate paid offset the reinvestment risk if the bond is called.

Bonds with call provisions pay a higher coupon interest rate than noncallable bonds.

The call provision allows companies to refinance their debt when interest rates fall.

The exercise of the call provision happens when rates fall, hitting investors with reinvestment risk.

In rising rate environments, the bond may pay a below-market interest rate.

Other Considerations with Call Provisions

Many municipal bonds can have call features based on a specified period such as five or 10 years. Municipal bonds are issued by state and local governments to fund projects such as building airports and infrastructure like sewer improvements.

Corporations can establish a sinking fund—an account funded over the years—where proceeds are earmarked to redeem bonds early. During a sinking-fund redemption, the issuer may only buy back the bonds according to a set schedule and might be restricted as to the number of bonds repurchased.

Real-World Example of a Call Provision

Let’s say Exxon Mobil Corp. (XOM) decides to borrow $20 million by issuing a callable bond. Each bond has a face value amount of $1,000 and pays a 5% interest rate with a maturity date in 10 years. As a result, Exxon pays $1,000,000 each year in interest to its bondholders (0.05 x $20 million = $1,000,000).

Five years after the bond’s issue, market interest rates fall to 2%. The drop prompts Exxon to exercise the call provision in the bonds. The company issues a new bond for $20 million at the current 2% rate and uses the proceeds to pay off the total principal from the callable bond. Exxon has refinanced its debt at a lower rate and now pays investors $400,000 in annual interest based on the 2% coupon rate.

Exxon saves $600,000 in interest while the original bondholders must now scramble to find a rate of return that’s comparable to the 5% offered by the callable bond.

Protective Call (Synthetic Long Put) Options Trading Strategy Explained

Published on Thursday, April 19, 2020 | Modified on Wednesday, June 5, 2020

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Protective Call (Synthetic Long Put) Options Strategy

Strategy Level Beginners
Instruments Traded Call + Underlying
Number of Positions 2
Market View Bearish
Risk Profile Limited
Reward Profile Unlimited
Breakeven Point Underlying Price – Call Premium

The Protective Call strategy is a hedging strategy. In this strategy, a trader shorts position in the underlying asset (sell shares or sell futures) and buys an ATM Call Option to cover against the rise in the price of the underlying.

This strategy is opposite of the Synthetic Call strategy. It is used when the trader is bearish on the underlying asset and would like to protect ‘rise in the price’ of the underlying asset.

The risk is limited in the strategy while the rewards are unlimited.

How to use a Protective Call trading strategy?

The usual Protective Call Strategy looks like as below for State Bank of India (SBI) Shares which are currently traded at в‚№275 (SBI Spot Price):

Protective Call Orders – SBI Stock

Orders SBI Strike Price
Sell Underlying Shares Sell 100 SBI Shares at в‚№275
Buy 1 ATM Call Option SBI18APR275CE

Suppose SBI shares are trading at в‚№275. You are of the view that the price will go down in near future and hence sell 100 shares. Now to protect yourself against a rise in the price and the resultant losses from it, you buy an ATM Call Option of SBI. If the price increases, your loss will be the difference between the strike price of call and strike price plus premium paid. If the prices fall, you will earn profits from the trade in underlying.

The Protective Call Strategy looks like as below for NIFTY which are currently traded at в‚№10400 (NIFTY Spot Price):

Protective Call Orders – NIFTY

Orders NIFTY Strike Price
Sell NIFTY Futures Sell 1 lot of NIFTY Future at в‚№10400
Buy 1 ATM Call Option NIFTY18APR10400CE

Suppose NIFTY is trading at 10400. If we are expecting the price of NIFTY to go down in near future, we sell 1 lot of NIFTY future. Now to protect ourselves against the rise in the price, we buy an ATM Call Option of NIFTY. If NIFTY goes up, our loss will be the difference between the strike price of call and strike price plus premium paid. If the NIFTY goes down, we will earn profits from the futures as we shorted it.

When to use Protective Call (Synthetic Long Put) strategy?

The Protective Call option strategy is used when you are bearish in market view and want to short shares to benefit from it. The strategy minimizes your risk in the event of prime movements going against your expectations.

Example

Example 1 – Stock Options:

Let’s take a simple example of a stock trading at в‚№50 (spot price) in June. The option contracts for this stock are available at the premium of:

Lot size: 100 shares in 1 lot

  1. Sell 100 Shares: 100*50 = в‚№5000 Received
  2. Buy ‘July 50 Call’: 100*2 = в‚№200

Now let’s discuss the possible scenarios:

Scenario 1: Stock price remains unchanged at в‚№50

  • Sell 100 Shares – No profit/loss except brokerage/taxes paid
  • July 50 Call – Expires worthless
  • Net Credit was в‚№4800 initially received to take the position.
  • Total Loss = в‚№200 which was paid as premium for Call position.

The total loss of в‚№200 is also the maximum loss in this strategy. This is the amount you paid a premium at the time you enter in the trade.

Scenario 2: Stock price goes to в‚№70

  • Sell 100 Shares: (50*100) – (70*100) = -в‚№2000
  • July 50 Call Expires in-the-money with an intrinsic value of (70-50)*100 = в‚№2000
  • Total Loss = – 2000 + 2000 – 200 (Premium Paid) = -в‚№200

In this scenario, в‚№2000 is the loss made from shares shorted. We earned в‚№2000 from the Call options position which nullifies the trade. The net loss made in this transaction is в‚№200 premium paid to take the Call Options position. This is also the maximum loss in this strategy.

Scenario 3: Stock price goes down to в‚№30

  • Sell 100 Shares: (50*100) – (30*100) = в‚№2000
  • July 50 Call – Expires worthless
  • Total Profit = 2000 – 200 (Premium Paid) = в‚№1800

In this scenario, в‚№2000 is the profit earn from shares shorted. We lost the premium paid for call position as it expired worthless. The net profit earned is в‚№1800.

Example 2 – Bank Nifty

Protective Call Example Bank Nifty
Bank Nifty Spot Price 8900
Bank Nifty Lot Size 25
Protective Call Options Strategy
Strike Price(в‚№) Premium(в‚№) Total Premium Paid(в‚№)
(Premium * lot size 25)
Sell 1 Future Lot 8900
Buy 1 ATM Call Option 8900 200 5000
Net Premium 200 5000
Breakeven(в‚№) Future Price – Call Premium
(8900 – 200)
8700
Maximum Possible Loss (в‚№) Net Call Premium Paid 5000
Maximum Possible Profit (в‚№) Unlimited
On Expiry Bank NIFTY closes at Payoff on Future Sold (в‚№) @8900 Payoff from 1 Call bought (в‚№) @8900 Net Payoff (в‚№)
8300 15000
(8900-8300)*25
-5000 10000
8500 10000
(8900-8500)*25
-5000 5000
8700 5000
(8900-8700)*25
-5000 0
8900 0
(8900-8900)*25
-5000 -5000
9100 -5000
(8900-9100)*25
0
(((9100-8900)*25)-5000)
-5000

Market View – Bearish

When you are bearish on the underlying but want to protect the upside.

Actions

  • Sell Underlying Stock or Future
  • Buy ATM Call Option

Breakeven Point

Underlying Price – Call Premium

Risk Profile of Protective Call (Synthetic Long Put)

Limited

The maximum loss is limited to the premium paid for buying the Call option. It occurs when the price of the underlying is less than the strike price of Call Option.

Maximum Loss = Call Strike Price – Sale Price of Underlying + Premium Paid

Reward Profile of Protective Call (Synthetic Long Put)

Unlimited

The maximum profit is unlimited in this strategy. The profit is dependent on the sale price of the underlying.

Profit = Sale Price of Underlying – Price of Underlying – Premium Paid

Max Profit Scenario of Protective Call (Synthetic Long Put)

Underlying goes down and Option not exercised

Max Loss Scenario of Protective Call (Synthetic Long Put)

Underlying goes down and Option exercised

Advantage of Protective Call (Synthetic Long Put)

Minimizes the risk when entering into a short position while keeping the profit potential limited.

Disadvantage of Protective Call (Synthetic Long Put)

Premium paid for Call Option may eat into your profits.

How to exit?

  • Wait for Option to expire.
  • Sell the Call Option and book profits.

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Collar

NOTE: This graph indicates profit and loss at expiration, respective to the stock value when you sold the call and bought the put.

The Strategy

Buying the put gives you the right to sell the stock at strike price A. Because you’ve also sold the call, you’ll be obligated to sell the stock at strike price B if the option is assigned.

You can think of a collar as simultaneously running a protective put and a covered call. Some investors think this is a sexy trade because the covered call helps to pay for the protective put. So you’ve limited the downside on the stock for less than it would cost to buy a put alone, but there’s a tradeoff.

The call you sell caps the upside. If the stock has exceeded strike B by expiration, it will most likely be called away. So you must be willing to sell it at that price.

Options Guy’s Tips

Many investors will run a collar when they’ve seen a nice run-up on the stock price, and they want to protect their unrealized profits against a downturn.

Some investors will try to sell the call with enough premium to pay for the put entirely. If established for net-zero cost, it is often referred to as a “zero-cost collar.” It may even be established for a net credit, if the call with strike price B is worth more than the put with strike price A.

Some investors will establish this strategy in a single trade. For every 100 shares they buy, they’ll sell one out-of-the-money call contract and buy one out-of-the-money put contract. This limits your downside risk instantly, but of course, it also limits your upside.

The Setup

  • You own the stock
  • Buy a put, strike price A
  • Sell a call, strike price B
  • Generally, the stock price will be between strikes A and B

NOTE: Both options have the same expiration month.

Who Should Run It

Rookies and higher

When to Run It

You’re bullish but nervous.

Break-even at Expiration

From the point the collar is established, there are two break-even points:

  • If established for a net credit, the break-even is current stock price minus net credit received.
  • If established for a net debit, the break-even is current stock price plus the net debit paid.

The Sweet Spot

You want the stock price to be above strike B at expiration and have the stock called away.

Maximum Potential Profit

From the point the collar is established, potential profit is limited to strike B minus current stock price minus the net debit paid, or plus net credit received.

Maximum Potential Loss

From the point the collar is established, risk is limited to the current stock price minus strike A plus the net debit paid, or minus the net credit received.

Ally Invest Margin Requirement

Because you own the stock, the call you sold is considered “covered.” So no additional margin is required after the trade is established.

As Time Goes By

For this strategy, the net effect of time decay is somewhat neutral. It will erode the value of the option you bought (bad) but it will also erode the value of the option you sold (good).

Implied Volatility

After the strategy is established, the net effect of an increase in implied volatility is somewhat neutral. The option you sold will increase in value (bad), but it will also increase the value of the option you bought (good).

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  • Use the Profit + Loss Calculator to establish break-even points, evaluate how your strategy might change as expiration approaches, and analyze the Option Greeks.

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What is a Covered Call? Learn the Pros and Cons

Before diving into the complexities of what a covered call trade is and how it can be used to generate portfolio income lets first define what an option contract is and what it means to each party involved. There are two main types of options, call options and put options. A call option is a contract that gives the holder (buyer) the right, but not the obligation, to buy a security at a specified price for a certain period of time.

Buying one call stock option gives the purchaser the right to buy 100 shares of a stock. If the stock price is greater than the options exercise (strike) price the option can be exercised and the option buyer will make a profit based on the difference between the current price and the strike price. When this happens the option is considered to be ‘in the money’. If the price of the stock is below the strike price on expiration the option becomes worthless or ‘out of the money’.

It is possible for an investor to either buy or sell options; selling naked calls means an investor sold a call option without owning any underlying stock to offset option. Selling naked calls is a very risky endeavor. If an investor sells a naked call and the stock dramatically rises above the options strike price the investor will owe 100 times the difference between the stock price and the options strike price.

Both buying call options and selling naked call options are speculative strategies where the investor stands to only make a profit if they correctly guessed the direction of the stock’s price.

Between the date the option contract is initiated and the date it expires the price of the stock will constantly fluctuate. The more a stocks price is expected to fluctuate over this time frame the harder it is to predict whether or not the option will be in the money at expiration. To account for this, options are priced at a premium, and that premium declines as the expiration date nears. All else held the same, an option expiring in one month will be worth more today than tomorrow if the stock price remains the same. For more detailed information on how options are priced read The Greeks: From Past to Present.

Covered Calls Explained

What is a covered call? Let’s now look at an example. XYZ stock is trading at $52 today; a call option to purchase XYZ at $55 one month from now is priced at $3. To initiate a covered call on XYZ stock an investor would purchase 100 shares of XYZ and sell a call option which obligates him to sell XYZ at $55 one month from now if exercised by the option buyer. For simplicity we will ignore commissions.

Pros of Selling Covered Calls for Income

– The seller receives the premium from writing the covered call immediately on the date of the transaction, in this case $300. If the price remains below $55 at option expiration the seller will keep the 100 shares of stock and the $300 he received for the option.

– If the price of the stock is over $55 at option expiration the call option will be exercised. At this point the 100 shares of stock are sold, the investors profit is equal to the $300 received for selling the option plus the $300 in capital appreciation (100 shares * ($55 sell price – $52 purchase price)) for a total profit of $600.

– The premium received can help offset a downward move in the stock price. In this example the investor purchased the shares at $52, if the stock were trading at $49 on expiration and the investor decided to sell his shares the total profit would be $0. The $3 loss on the shares of stock is offset by the $3 received in option premium.

Cons of Selling Covered Calls for Income

– If the stock rises well above the strike price, the seller does not enjoy the full appreciation. The seller’s profit is limited to the premium received plus the difference between the stocks purchase price and the options strike price.

The option seller cannot sell the underlying stock without first buying back the call option. A significant drop in the price of the stock (greater than the premium) will result in a loss on the entire transaction.

– Premium amounts are based on the historical volatility of the underlying stock. Stocks with higher option premiums will have a greater risk of price fluctuation.

– Losses due to downward moves in the underlying stocks price are only limited by the amount of premium received.

Is Selling Covered Calls “Worth It”?

As you can see, selling covered calls for income offers both advantages and disadvantages to outright stock ownership. They can be a great tool to generate additional income from an equity portfolio; however using only a simple covered call strategy can get you into trouble due to its limited upside potential and limited downside protection.

Strategies using options to generate income can be as simple as selling covered calls, while others add strict rules and processes to manage income, emotion and risk. If you are looking to add an income producing strategy using options, compare the risk/reward profiles of every strategy and pick one that matches your objectives, risk tolerance, time horizon and temperament. For more information on using options in your portfolio read our free special report: Myths & Misconceptions About Exchange Traded Options.

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