Cash-Backed Calls

Definition

The term cash-backed call refers to the strategy of setting aside enough money in an interest-bearing account to exercise a call option purchased by the investor.  Cash-backed calls allow the investor to purchase a stock at the lower of the call's strike price or market.

Explanation

A cashed-backed call involves the purchase of a call and the setting aside of enough money in a brokerage account to pay for the securities.  The premium paid for the cash-backed call allows the investor to delay their purchase decision.  As a reminder, a long call gives the investor the right to buy the stock at the strike price.  There are two possible outcomes when using this strategy:

  • Stock Price Increases: if the price of the stock rises above the call's strike price, the investor can exercise their right to purchase the securities at the strike price or sell the in-the-money option.
  • Stock Price Declines:  if the price of the stock remains below the call's strike price, the call will expire out-of-the-money.

By delaying their purchase decision, the investor can determine if the stock's performance is fundamentally better or worse than originally thought.  In this manner, the premium paid on the call acts like an insurance policy.

The maximum gain possible with this approach is theoretically unlimited, since the investor has the option to exercise their right and purchase the security at the strike price regardless of how high the price of the security rises.  The maximum loss is the premium paid on the call.  However, the investor may also see a near term decline in the stock's price as a positive event, since the delay now allows them to purchase the stock at a lower price point.

Expressing the breakeven point for this strategy is complicated by the fact the investor had the option of purchasing the stock instead of delaying the decision using a cash-backed call.  For that reason, there are several ways the breakeven stock price can be expressed.

If the stock were to rise above the call's strike price, the breakeven point would be calculated as:

= Stock Price + Premium Paid for the Option

However, this strategy assumes the investor would like to hold the stock in their portfolio, so the delay in the purchase decision may be a benefit and the breakeven calculated as:

= Original Stock Price - Premium Paid for the Option

Related Terms

assignment, adjustment, bull call spread