Basic Covered Call Example
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Dan Passarelli MarketTaker .com |
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Let’s get back to basics. A potentially beneficial trading strategy when you own a stock but are not very bullish in the short-term, is the covered call. The covered call is used if the investor wants to generate additional income from the underlying stock and hopes to provide some protection against a drop in the stock's price. The covered call is generally considered a conservative strategy, as it partially offsets the risk of owning the stock. Someone investing with a covered call can benefit in any market condition; but a covered call is most often used when moderately bullish on the underlying stock.
To execute a covered call, an investor will write (sell) a call option while owning the equivalent number of shares of the underlying stock. A covered call gives an investor some protection against the underlying stock's decline (though not a lot). The investor selling the call will pocket the premium for the option position and will still own the underlying stock. The potential profit is limited to the premium received for the call option plus appreciation of the stock price up to the strike. The maximum loss is substantial, as it is associated with the ownership of the underlying stock. At expiration, if the option is assigned, the profit is the premium received plus any difference between the strike price and the stock purchase price. If the option is not assigned, the profit or loss is represented by any gains or losses in the stock plus the premium received.
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Let's take a look at this trading strategy. In this example, we will have the investor selling a call and purchasing the stock at the same time (which is often referred to as a buy-write) although the call seller could have owned the stock for quite some time (which is called an overwrite).
Hypothetically, our investor sells the April 22 call, which carries a bid price of, say, $1. Our investor now has $1 in his pocket and still owns 100 shares of the stock, which was purchased for, say $20. If the option is assigned at expiration and the stock is at, say, $22.50, the investor profits the $1 plus the appreciation in the stock price from $20 to $22 (the strike), for a grand total of $3. The stock price appreciation from $22 (again, the strike) to $22.50 is forgone. Why? Because when the call is assigned, the stock is sold at $22 and any upward price gains beyond that are foregone.
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Dan Passarelli, is the author of the book Trading Option Greeks and founder of Market Taker Mentoring LLCTM. Market Taker Mentoring provides personalized one-on-one mentoring for option traders. The company website is http://www.markettaker.com.
Dan started his trading career on the floor of the Chicago Board Options Exchange (CBOE) as an equity options market maker. He also traded agricultural options and futures on the floor of the Chicago Board of Trade (CBOT). In 2005, Dan joined CBOE’s Options Institute and began teaching both basic and advanced trading concepts to retail traders, brokers, institutional traders, financial planners and advisors, money managers, employees of the SEC and Federal Reserve Bank, and market makers. In addition to his work with the CBOE, he taught options strategies at the Options Industry Council (OIC). Dan has been featured on television and radio and has written numerous articles in the financial press. Dan can be reached at dan@markettaker.com. He can be followed on Twitter at twitter.com/Dan_Passarelli.
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