Covered Call (aka Buy-Write)

Objective: To profit from slow upward drifts in the chosen underlying OR from a sideways moving underlying

Definition: A covered call consists of purchasing 100 shares of stock and bringing in additional revenue by selling a call at a strike price higher than the current stock level. For example, you would buy stock for $100 per share and sell ONE 105 call at $2 or $200 per contract. This formula works regardless of the underlying’s price.

Maximum Risk: Find maximum risk by taking the original purchase price of the stock and SUBTRACTING the premium collected from the call sale.

[e.g. $100 stock * 100 shares – $200 collected on call sale = $10,000 – $200 = $9,800 per covered call position]

Maximum Profit: Find maximum profit by taking the distance between stock purchase price and the short call strike and ADDING the short call premium collected. [e.g. ($105 – $100 + $2) * 100 shares = $7 *100 shares = $700]

Benefits: Covered calls are usually the first option strategy introduced to traders. They allow traders to benefit from upward movement in the stock and from time decay on the short option position.

Break-even (B/E): The B/E is the price the stock must remain above at expiration for the trade to breakeven. You can find the break-even of a covered call by taking the stock purchase price and SUBTRACTING the premium collected on the short option. If you bought stock for $100 and sold the 105 call for $2, then the B/E would be $98 (100 stock purchase price – $2 credit from short call).

There is no time value left when an optionis at expiration.  Therefore, if the stock closes lower than the B/E at expiration, then a loss will occur. If the stock closes above the B/E at expiration, then a profit will occur. The chart below illustrates what happens at expiration at various stock prices:

Covered Call Profit and Loss

Stock

Long Stock Price at $100

Short 105 Call

=

Position Value

+ Call Credit

=

Profit or Loss

150 $50.00 -$45.00 = $5.00 $2.00 = $7.00
115 $15.00 -$10.00 = $5.00 $2.00 = $7.00
110 $10.00 -$5.00 = $5.00 $2.00 = $7.00
107 $7.00 -$2.00 = $5.00 $2.00 = $7.00
106 $6.00 -$1.00 = $5.00 $2.00 = $7.00
105 $5.00 $0.00 = $5.00 $2.00 = $7.00
104 $4.00 $0.00 = $4.00 $2.00 = $6.00
103 $3.00 $0.00 = $3.00 $2.00 = $5.00
102 $2.00 $0.00 = $2.00 $2.00 = $4.00
101 $1.00 $0.00 = $1.00 $2.00 = $3.00
100 $0.00 $0.00 = $0.00 $2.00 = $2.00
99 -$1.00 $0.00 = -$1.00 $2.00 = $1.00
98 -$2.00 $0.00 = -$2.00 $2.00 = $0.00
95 -$5.00 $0.00 = -$5.00 $2.00 = -$3.00
50 -$50.00 $0.00 = -$50.00 $2.00 = -$48.00

The profit and loss graph included below also depicts the Covered Call.