According to investopedia a covered call is an options strategy where an investor holds a long position in a stock or ETF and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason holds the asset long and simultaneously has a short position via the option to generate income from the option premium.
This is also known as a “buy-write”. For example, let’s say that you own shares of the TSJ Sports Conglomerate and like its long-term prospects as well as its share price but feel in the shorter term the stock will likely trade relatively flat, perhaps within a few dollars of its current price of, say, $25. If you sell a call option on TSJ for $25.00, you earn the premium from the option sale but cap your upside. One of three scenarios is going to play out:
a) TSJ shares trade flat (below the $25 strike price) – the option will expire worthless and you keep the premium from the option. In this case, by using the buy-write strategy you have successfully outperformed the stock.
b) TSJ shares fall – the option expires worthless, you keep the premium, and again you outperform the stock.
c) TSJ shares rise above $25 – the option is exercised, and your upside is capped at $25, plus the option premium. In this case, if the stock price goes higher than $25, plus the premium, your buy-write strategy has underperformed the TSJ shares.
The risk graph of a covered call looks as follows:
Covered Call
Assuming that the premium for the short option is 1.46 you see that the break-even point is (25-1.46) or 23.54. Also, the maximum profit is 146 dollars for the position. Obviously, there is no downside protection. If you where to purchase a protective put the position will get downside protection. However, the maximum profit is reduced due to the purchase of the protective put. This new position is called a Collar. Another option that the option strategist would have is to roll down the short option to a lower strike price in case that the stock plunges in value. However, keep in mind that the premium would be lower as the stock loses value (assuming that volatility stays constant).
Popularity: 3% [?]
I am a dad, professional engineer, MBA student, and a financial fanatic. I can help you make money in the stock market. I use Fibonacci techniques for retracements and targets, technical analysis, some little fundamental analysis, and automated systems trading. I also trade options. In addition, I use CANSLIM to get neat growth stock ideas. No fluff and no BS.
If you want to discuss stocks, options or personal finance you are welcome to follow me in Twitter (@smarkethacker) or drop me a line to smh@stockmarkethacker.com. In addition, consider subscribing to my RSS feed located in the top right hand corner.