An option is an agreement that enables the holder of the financial instrument the right to sell or buy. This buying or selling is at a strike price on a specified date with no obligations involved (Habib & Ljungqvist, 2005). There are two types of options. These types include put and call option. A call option is one for buying a financial instrument at a specified price. On the other hand, a put option is one for selling a financial instrument at specified price. A protective put is a strategy where the holder of the financial instrument buys a put option to avoid a drop in its stock price. On the other hand, a covered call is a strategy in the trading options whereby a call option is written against a holding of an underlying asset.
Selling short of a security refers to its sale borrowed by a trader, prompted by speculation to hedge a risk in the asset for the long downside position. Motivation is in the belief that an asset’s value will fall, facilitating it to be bought back at a lower price to obtain a gain. Zhou and Shon (2012) argue that the use of a protective put strategy would act to counter selling short of security since it guards against the drop in the price of financial assets. It would mean that there would be no motivation for an investor to sell short. An investor can decide to hold his protective put when the market is not promising in terms of making a gain. Once the market becomes favorable for him, he can then do the selling comfortably and get the necessary returns (Teall, 2012).
However, considering the same circumstances covered call strategy would be the policy in line with selling short. This selling short enables an investor to write against the assets he holds so as to gain a premium. Consequently, a holder of a covered call would sell them to make a gain since the market would be favorable then. If he delays and fails to sell then, it will be an ultimate loss (Grünbichler & Wohlwend 2005).
Grünbichler, A., & Wohlwend, H. (2005). The valuation of structured products: Empirical findings for the Swiss market. Financial markets and portfolio management, 19(4), 361-380.
Habib, M. A., & Ljungqvist, A. (2005). Firm Value and Managerial Incentives: A Stochastic Frontier Approach*. The Journal of Business, 78(6), 2053-2094.
Horan, S. M., Peterson, J. H., & Mahar, J. (2004). Implied volatility of oil futures options surrounding OPEC meetings. The Energy Journal, 103-125.
Teall, J. L. (2012). Financial trading and investing. Academic Press.
Zhou, P., & Shon, J. (2012). Option Strategies for Earnings Announcements: A Comprehensive, Empirical Analysis. FT Press.