Covered calls, protective puts and swaps
◈ 12 cardsLong stock plus a short call caps the upside for income; long stock plus a long put floors the downside for a premium; and a plain-vanilla swap exchanges fixed for floating interest on a notional that never moves.
Covered call — income that caps the upside
An investor owns Tamarack Foods at $48 and writes the 50 call for $3.20. She is covered because if the call is exercised she already holds the shares to deliver; a writer without the shares is naked (Lesson 12.5's unlimited loss). Her profit per share at expiry:
At 58: the call is exercised, her shares are called away at 50, and =(MIN(58,50)-48)+3.20 = 5.20. She made 2.00 on the shares and kept the 3.20 premium — and that is the most she can make at any price above 50. The rally to 58 was the call holder's. At 42: the call expires worthless, she keeps the shares, and =(MIN(42,50)-48)+3.20 = −2.80 — a 6.00 loss on the shares cushioned by the premium. A covered call sells the upside above the strike for income; it does not protect the downside beyond the premium received.
Protective put — insurance with a deductible
The same investor, still long at 48, instead buys the 45 put for $2.10:
At 38: she exercises and sells at 45; =(MAX(38,45)-48)-2.10 = −5.10 — and −5.10 is the worst outcome at any price below 45. The put is a floor. At 58: the put expires worthless; =(MAX(58,45)-48)-2.10 = 7.90 — she keeps the rise less the premium. A protective put is insurance: the premium (2.10) is the cost, and the gap from 48 down to the 45 strike (3.00) is the deductible she absorbs before the cover pays. Total maximum loss: 3.00 + 2.10 = 5.10. Compare the two: the covered call is paid to give up the upside; the protective put pays to keep it while capping the downside.
Swaps — exchanging only the net
A swap is an OTC agreement to exchange two streams of cash flows. In a plain-vanilla interest-rate swap, Prairie Grid Energy has borrowed at a floating rate and wants certainty; it agrees with a bank to pay fixed 4.2 % and receive floating (the floating index in Canada is CORRA, the overnight rate, since CDOR ceased in June 2024) on a notional of $10,000,000 for five years. The notional is never exchanged — it is only the number the interest is computed on. Each period the two amounts are netted and one payment moves. If floating averages 3.6 % for the year:
=10000000*(0.042-0.036) = $60,000 paid by Prairie Grid.
If floating had been 4.9 %, Prairie Grid would receive 70,000. Combined with its floating-rate loan, Prairie Grid now pays fixed 4.2 % all-in whatever CORRA does — the swap converted a floating liability into a fixed one without refinancing. A currency swap goes further: the two parties exchange principal in two currencies at the start, pay each other interest in those currencies over the term, and re-exchange the principal at the end — an exporter with US-dollar revenue can service Canadian-dollar debt that way. Swaps are OTC, bilateral and customised, like forwards; unlike futures they are not listed on the MX, although CDCC does clear some OTC products.
Recompute
Covered call at 50: =(MIN(50,50)-48)+3.20 = 5.20 — the cap is reached exactly at the strike. Protective put at 50: =(MAX(50,45)-48)-2.10 = −0.10. Cold: a plain-vanilla swap exchanges fixed for floating interest on a notional; only the net is paid; the notional never moves.