What are Covered Calls?
A covered call is an option trading strategy where the trader has a long position on the underlying asset and then sells a call option on the same asset in the options market, in order to generate more revenue from the same asset.
This strategy is usually employed when the trader expects the price of the asset to appreciate in the long term, but to remain flat in the short term. So instead of just tying down capital waiting out the stock, the trader can employ the covered call option to make some money in the interim from the premium on the trade.
For this trade example, Mr John purchases 100 shares of stock XY at $99 a share, totalling $9,900 (transaction costs excluded). John decides to write a covered call (i.e. purchases a short covered call) on XY to the dealer. The dealer pays a premium of $2 per share (or $200 for the covered call contract) to John, at a strike price of $105 with a 2-month expiration. In selling the covered call, the downside risk of his long position on XY has been reduced by $2 per share to $97. So the covered call now “covers” a $2 decline in the share price of XY.
In setting up the covered call options trade, Mr John earns a premium of $200 for the contract. If the stock price of XY eventually picks up to $105 or more before expiration of the covered call, John can exercise the covered call by offloading the very same shares that he owns in XY to the dealer at the strike price. The dealer will therefore pay Mr John $105 X 100 = $10,500 for the 100 shares of XY owned in the stock market. Mr John will therefore profit both from the premium and the exercised option on XY.
Net profit = ($10,500 – $9,900) + $200 = $800.
The breakeven point for this trade is at $97. This is because if the stock XY falls from the original purchase price of $99 per share to $97 per share, Mr John can sell XY in the stock market and lose only $2 per share. He owns 100 shares, so the total loss of the sale of the stock is $200. This $200 is defrayed by the $200 premium earned on the covered call option trade.
If the price of the stock falls below $97, then Mr John will suffer a net loss as the $200 premium earned on the covered call option will not cover for any losses incurred by stock price drop below the breakeven point of $97.
The good thing about the covered call option trade is that a trader can easily calculate his breakeven point, and sell off his stock holdings as soon as stock price depreciation approaches these levels, so as to mitigate against any loss.
Of course, if the trader is spot on and the price of the stock starts to appreciate, he can easily exercise his option before expiration and smile to the bank with his double earnings.
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