Covered Call

Definition

The owner of the Equity/ stock sells the CALL Options (generally out of money) and receives the premium. He is willing to sell the stock if called (stock price at expiration more than the Strike price).

If the trader buys to stock to get into the Covered Call, it is generally called Buy/Write.

 

When to run the strategy

The owner of the Stock is expecting the Stock to go up slightly or remain at current price and ready to get out of trade with slight gain.

The Strategy can be used as a constant cash flow strategy if you are ready to get out of positions with some gain.

 

Benefits of strategy

 

·         You own the underlying stock and don’t require to sell it till called for.

·         If the stock price falls down, the loss may be covered by the gain because of selling the call.

·         Can be a good cash flow strategy if you are long on the stock.

 

Transactions

·         You buy the Equity at Price (E) (say $100).

·         You Sell the call (generally Out of the Money) at the Strike Price (S) (say $110).

·         You receive the premium (P) (say $7).

Max Profit

 

Max profit is capped at

Strike Price – Stock Purchase Price + Premium

Example:

Stock Purchase Price:     $100

Strike Price:                    $110

Premium:                       $7

So Max Profit = $110 - $100 + $7 = $17

Potential and Max Loss

Potential Loss is

(Stock Purchase Price – Premium) - Stock Price at Expiration

Example, 

          Stock Purchase Price          $100

          Stock Price at Expiration (say): $70

          Premium:                            $7

So Potential Loss= ($100 - $7) - $70 = $23

Max Loss occurs when the stock value is reduced to 0.

Max loss = Stock Purchase price - Premium

Note: You still own the stock so the loss is notional till you book the loss.

Break even point

 

This occurs when the loss in Stock is compensated by the premium received. It occurs when the stock price at expiration is (Stock Purchase Price – Premium).

Example:

Stock Purchase Price - $100

Premium - $7

So Stock price at breakeven point should be (100-7) = $93

 

At Expiration

 

Ø If the Stock price is above Strike price:

The Stock is called i.e., Stock is removed from your portfolio and the amount equal to Strike price is credited in your account.

Ø If the Stock price is below Strike price:

The CALL Option expires worthless.

The Stock remains in your account.

Who should trade this?

 

Since this strategy has low risk, it can be traded by people at all level

Beginners               - Yes

Intermediates          - Yes

Experts                   - Yes

Masters                   - Yes

Time decay

Ø Time Decay will work in your support.

Ø As Expiration date approaches, the time value of Option will reduce.

Ø The time values reduces to 0 on the day of Expiration.

Points to consider

Ø Exit strategy: If Stock falls, you require to close the CALL position by buying the CALL and sell the stock.

Ø Brokerage Cost: Always consider brokerage cost when making a trade. Sometimes the significant part of the premium received is used in Brokerage.