Set out the payoffs from a covered call and a protective put
The idea
A protective put pairs a long position in the underlying with a long put: the downside is capped at the exercise price less the premium, while the upside is reduced by the premium but otherwise intact. It is insurance and is priced like insurance. A covered call pairs a long underlying with a written call: the premium is received and enhances return in flat markets, but any gain above the exercise price is forgone. Neither strategy is free - one pays for protection, the other sells away upside to be paid.
Formulas
Protective put profit
Π = S + max(0, X − S) − S₀ − p
- Π
- the profit
- S
- the share price at expiry
- X
- the exercise price of the put
- S₀
- the price paid for the share
- p
- the put premium
The floor is the exercise price: the worst loss is S₀ + p − X.
Covered call profit
Π = S − max(0, S − X) − S₀ + c
- Π
- the profit
- S
- the share price at expiry
- X
- the exercise price of the call
- S₀
- the price paid for the share
- c
- the call premium received
The cap is the exercise price: the best profit is X − S₀ + c.
A practice question
What does a protective put provide to a holder of the underlying?
- A floor on the value of the position, at the cost of the premium - correct
- A guaranteed profit regardless of the underlying's pathWhy not: It guarantees a floor, not a profit. If the underlying is flat the premium is simply lost.
- Elimination of the premium cost through hedgingWhy not: The premium is the cost of the protection and is paid whatever happens.
A protective put means you own the asset and also buy a put, which gives you the right to sell at the exercise price. That sets a floor under your position. You pay the premium for this insurance. Worst-case loss = Purchase price − Exercise price + Premium. Example: a share worth 100, a put with exercise price 95 and premium 3. The position cannot be worth less than 95, so the worst loss = 100 − 95 + 3 = 8. If the share does not move, the 3 premium is simply lost.
A harder one
What does an investor give up by writing a covered call?
- The dividend on the underlyingWhy not: The shares are still owned until exercise, so dividends continue to be received.
- Any appreciation of the underlying above the exercise price - correct
- The right to sell the underlying at any timeWhy not: The shares can be sold, though doing so leaves the call uncovered.
A covered call means you own the share and sell someone a call on it, collecting a premium. If the share ends above the exercise price, the buyer takes it at the exercise price, so you miss the extra gain. Maximum profit = (Exercise price − Purchase price) + Premium. Example: bought at 50, call written at exercise price 55 for premium 2. Maximum profit = 5 + 2 = 7, even if the share rises to 70. The premium helps in flat, falling or slightly rising markets.
The hardest tier
In which market environment does a covered call most clearly underperform simply holding the underlying?
- A flat market, where the premium is the only returnWhy not: The best case for the strategy: the call expires worthless and the premium is pure gain.
- A falling market, because the premium gives no protectionWhy not: The premium cushions a fall, so the covered call beats holding the shares alone here.
- A strong rally, because gains above the exercise price are forgone - correct
The premium you collect is a small fixed amount. But the gains you give up when the share soars have no limit. Covered call profit at expiry = Share gain up to the exercise price + Premium. Example: share bought at 50, call written at exercise price 55 for premium 2. If the share rises to 70, the covered call earns 5 + 2 = 7, but simply holding the share earns 70 − 50 = 20. In a flat or falling market the premium helps instead.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →