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.
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.
The put gives the right to sell at the exercise price, so the position cannot be worth less than that, less what the protection cost.
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.
The call writer has sold the upside past the strike. In return the premium improves the return in flat or modestly 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 provides no protection at allWhy not: The premium cushions a fall, so the covered call beats holding the shares alone here.
- A strongly rising market, where the forgone upside far exceeds the premium received — correct
The premium is a fixed, modest amount while the surrendered appreciation is unbounded. In a sharp rally the strategy's return is capped near the strike while the unhedged holder keeps rising.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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