Don’t both provide a floor to your investment? I came across this question and it bothered me… I think it was in one of the PM mocks implying that only the protective put does…
Only protective put does. Covered call is a synthetic short put payoff and p/l. The stock price can fall to zero and you’ll lose money. Your gains are capped to the premium received. In a way, it provides a floor because the stock price can’t go negative but it isn’t a floor in general since you lose money real bad if the stock price keeps falling. A floor should protect your downside considerably which this doesn’t. Protective put is a synthetic long call position. Your loss is limited to the premium paid which provides a floor. Gains are unlimited.
A covered call provides a ceiling, not a floor.
Shorting a call option while holding an underlying caps your price appreciation.
Longing a put option while holding an underlying floors your price loss.
No, protective put does, but a covered call is considered a yield enhacement strategy. You have the underlying and you sell a call otm ( better) and you get the premium for the sell. This increase your “yield” earn by your position if the call is not exercised.
this is my point here - if your underlying is $100 and you sell a call and receive $2… isn’t the “floor” $2 if the stock goes to zero? yes the loss is huge but its _still a floor??
i wont get this question wrong if it comes up on the exam but seems to be an issue of semantics here… in other scenarios the preimum received could be substantial… what if your stock is at $100 and you sell long dated $50 calls and receive $55 in premium… is that a covered call and would that premium income be considered a floor?
I too got this question wrong due to your exact logic. The only way I can justify this was that the floor or ceiling refers to a stock price, rather than a certain total value. Not sure if that’s the way to approach it, but that’s all I can muster up
That’s exactly what it means.
Having your portfolio fall to 0 is obviously a floor, but not the kind of floor you should be looking for, hence paying a premium to raise it up.
I think you may be overcomplicating it.
The question seems to want to test whether or not you know the difference between a covered call and a protective put, by design one cap your profit while the other floor it, look no further.
I can appreciate the intellectual exercise but it would probably cost you a lot of time on the exam. I believe it helps a lot to think about what the CFAI is trying to test and the traps lying around, here it is kind of straightforward
Then I’ll rephrase it. A covered call gives you a floor on the sense that it gives a stop loss. A stock is @ 100 and the atm call @ 5. So you start making a loss if the stock goes below 95. In other words, 95 is your stop loss or in a sense, your floor.
A covered call means writing a call. It’s a ceiling on price, not a floor.
Both are tied to the underlying, that’s how you remember them. As opposed to naked options.
Of course I do know that. It’s a cap on the price no doubt. I just wanted to mention that if you want to call a stop loss on a stock as a floor then this is what it is.