This is a strategy wherein an investor has gone short on a stock and buys a call to hedge it.
This is the opposite of a synthetic Call (Strategy 3). An investor sells or shorts a stock and buys an At The Money (ATM) or slightly Out of The Money (OTM) Call.
[An ATM call is one whose strike price is at or very near to the current market price of the underlying security.
An OTM call is one whose strike price is higher than the market price of the underlying asset.]
The net effect of this is that the investor creates a pay-off like a long Put, but instead of having a net debit (paying premium) for a long Put, he creates a net credit (receives money on shorting the stock). In case the stock price falls, the investor gains in the downward fall in the price. However, in case there is an unexpected rise in the price of the stock, the loss is limited. The pay-off from the Long Call will increase, thereby compensating for the loss in the value of the short stock position. This strategy hedges the upside in the stock position while retaining downside profit potential.
When to Use: If the investor is of the view that the markets will go down (bearish) but wants to protect against any unexpected rise in the price of the stock.
Risk: Limited. The maximum risk is Call strike price – Stock price + Premium
Reward: Maximum is the stock price – Call premium
Breakeven: Stock price – Call premium