An investor who sells stock short believes that they can profit from a fall in the stock price by selling it high and repurchasing it cheaper. An investor who has sold stock short is subject to an unlimited loss if the stock price should begin to rise. Once again, there is no limit to how high a stock price may rise. An investor who has sold stock short would receive the most protection by purchasing a call. A long call could be used to guard against a loss or to protect a profit on a short stock position. By purchasing the call, the investor has set the maximum price that they will have to pay to repurchase the stock for the life of the option. Before establishing a short stock long call position, the investor will have to determine:

  • Their Breakeven
  • Their Maximum Gain
  • Their Maximum Loss

Determining The Breakeven Short Stock Long Calls

An investor who has sold stock short will profit from a fall in the stock price. When an investor has purchased a call to protect their position, the stock price must fall by enough to offset the premium the investor paid for the call.

To determine the breakeven for a short stock long call position, use the following formula:

Example:

Breakeven = Stock Price – Premium

An investor establishes the following position:

Short 100 ABC at 60

Long 1 ABC October 60 call at 2

Using the above formula, we get:

60 – 2 = 58

The stock would have to fall to $58 by expiration in order for the investor to breakeven.

Maximum Gain Short Stock Long Calls

The maximum gain on the short sale of stock is always limited because a stock cannot fall below zero. When an investor has a short stock long call position, their maximum gain is found by using the following formula:

Maximum Gain = Breakeven – 0

Said another way, the investor’s maximum gain per share would be equal to their breakeven price per share. Using the same example as above, we get:

Example:

An investor establishes the following position:

Short 100 ABC at 60

Long 1 ABC October 60 call at 2

Using the above formula we get:

58 - 0 = 58

If the stock fell to $0 by expiration, the investor would realize their maximum gain of $58 per share or $5,800 for the entire position.

Maximum Loss Short Stock Long Call

An investor who has sold stock short and has purchased a call to protect their position is only subject to a loss up to the strike price of the call. In order to determine the investor’s maximum loss, use the following formula:

Maximum Loss = Strike Price – Breakeven

Example:

An investor establishes the following position:

Short 100 ABC at 60

Long 1 ABC October 60 call at 2

60 - 58 = 2

The investor is subject to a loss of $2 per share or $200 for the entire position. Notice that the price at which the investor sold the stock short at and the strike price of the call are the same. As a result, the investor has set a maximum repurchase price equal to the price at which they sold the stock short. The investor’s maximum loss when the sale price and strike price are the same is the amount of the premium that the investor paid for the call. Let’s take a look at a position where the sale price of the stock and strike price of the option are different.

Example:

An investor establishes the following position:

Short 100 ABC at 56

Long 1 ABC October 60 call at 2

This investor will breakeven at $54 per share. To determine their maximum loss, subtract the breakeven from the strike price of the option.

60 - 54 = 6

The investor is subject to a loss of $6 per share or $600 for the entire position.

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