A pension CIO holds $400 million in equities, expects flat markets, and cannot afford a 5% drawdown. Selling equities violates the 60% policy. Three derivatives structures (covered call, collar, put spread) each reshape the return distribution differently. The wrong choice costs millions.
A covered call combines long stock with a short call. The short call generates premium but caps upside at the strike price.
Maximum gain = Strike - Purchase price + Premium received
Maximum loss = Purchase price - Premium (stock goes to zero)
Breakeven = Purchase price - Premium
HIGH-FREQUENCY: Covered call payoff is heavily tested. The critical insight: the short call does NOT reduce downside risk. It provides only a small premium cushion. Candidates who describe covered calls as "hedged" lose marks.
By put-call parity, a covered call (long stock + short call) is equivalent to a short put at the same strike. Both have the same payoff: limited upside, full downside minus premium.
Appropriate when the manager is neutral-to-slightly-bullish and wants yield enhancement during low-volatility periods.
Common mistakes
- Calling covered calls "hedged." Covered calls cap upside and provide a small premium cushion but do not limit downside. They are yield enhancement, not hedges. The payoff is identical to a short put.
- Forgetting the premium when computing breakeven and max loss. The premium is part of every options calculation. Breakeven for a protective put is stock price PLUS premium, not stock price minus premium.
- Confusing the strategies' appropriate market views. Covered call = neutral. Protective put = bullish with insurance. Collar = neutral wanting defined range. Straddle = volatile, no direction. Candidates who recommend a straddle for a bullish view are wrong.
Bottom line
- Covered call = long stock + short call: caps upside, earns premium, does NOT hedge downside (payoff identical to a short put).
- Protective put = long stock + long put: sets a floor, preserves unlimited upside, costs the premium (breakeven = stock price + premium).
- Collar = long stock + long OTM put + short OTM call: floor and cap, can be zero-cost by sacrificing upside.
- Bull call spread = long lower-strike call + short higher-strike call: capped directional bet, defined risk; spreads cap both gains and losses.
Exam shortcut
Match strategy to view: flat = covered call, need floor = protective put, need range = collar, moderately directional = spread, expecting vol = straddle. For payoff calculations, always account for the premium, it appears in breakeven, max gain, and max loss.
The full lesson (about 4,771 words, 32 min read) adds 2 worked examples, all 9 common mistakes, a self-check, free in the app.
Learning objectives
- options strategies
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