Covered Call

The Covered Call Setup

Suppose you own 100 shares of a company named TechGrowth, and it is currently trading at $100 per share. You would sell a call option on the shares with a strike price of $110 that expires in 1 month’s time and receive a premium of $5 for each option sold.

Ideal Candidates

The covered call strategy is best suited for investors with neutral to mildly bullish views on the underlying stock. It is ideal for those who seek some passive income in the form of option premiums while other factors suggest a very limited upside in the short term.

Strategy Elucidation

As by selling a call option, you are giving the buyer the right to buy your shares at the strike price. The option buyer will choose to exercise the option if at expiration time the stock price exceeds the strike price. If the stock price stays below the strike price by the time of expiry, the option will expire worthless and you keep the premium as profit and keep the stock as is.

Breakeven Methodology

The breakeven process for a covered call strategy is the deduction of the premium earned from your original cost basis in the stock. For instance, if your cost basis was $95 per share and, say, you received $5 per share in option premiums, your adjusted cost basis equals $90 per share.

Sweet Spot

The sweet spot for this strategy occurs when the stock price is right at or slightly below the strike price at expiration. Such a scenario allows you to keep both the premium and your shares, thus maximizing income while maintaining your stock position.

Max Profit Potential

Maximum profit is limited to the premium received plus the gain on the shares if they are called away. In the TechGrowth example, if the stock ends up at $110, you gain $10 per share on the stock ($110 - $100) plus the $5 premium, totaling $15 per share.

Max Loss

The maximum loss would occur when the price of the stock goes to zero. In this case, you would lose all your value in the stock position, which amounts to your initial investment minus whatever premium you received. Therefore, although the premium offers some degree of downside protection, it does not eliminate the general risk of holding the stock.

Risk

The risk is primarily that of holding the stock itself. The covered call strategy offers minimal protection against further decline in stock price. However, the premium received does provide slight protection against losses.

Time Decay

Time decay works for you. The closer the call option gets to its expiration date, the more its value erodes, so long as the stock price does not exceed the strike price. This increases the odds that you get to keep the entire premium.

Implied Volatility

The higher the implied volatility, the higher will be the premium you can seek when selling the call option, thus raising the maximum potential return from the strategy. Conversely, if the volatility drops after you’ve sold the call, this is beneficial for you since it decreases the chance that the option will be exercised.

Conclusion

The strategy of a covered call is a conservative way to earn an income on your stock holdings, which offers slight downside protection. Among investors who are seeking income in return for giving up some upside potential on the stocks they own, this strategy is quite appealing. The consideration of both the strike price and the expiration is important in making a decision to achieve a balance between higher earning potential and the risk of losing stock at too low a price.