A Covered Call is an – Options strategy that is executed by – Selling Call Options on a stock that you already own. Usually, you need to own at least a 100 shares, before you execute a covered-call.
Let’s take this example – I own 100 Microsoft shares at $17.50, and sell a Microsoft Call Option at 17.50 which trades at $2.90, and expires one year from now.
I receive a premium of $290 from the call option that I sell.
So my portfolio is:
- 100 shares of Microsoft – $1750
- Premium Earned – $290
Now, after three months – say Microsoft trades at the following prices:
1. $17.50: If Microsoft trades at 17.50, then my call option will not be exercised because the buyer of the call option can buy the stock cheaper in the market. So that means I profit $290 from my Call Option, and my stock portfolio remains flat.
2. $14.60: If the stock trades at 14.60, then again – my call option will not be exercised, but the loss on my Microsoft portfolio will be $290, and so I am in a no profit – no loss situation.
3. $10.00: If the stock trades at $10.00 – I make a loss of $750 on my portfolio, but my call option will not be exercised so my loss will be $750 – $290 = $460.
4. $25.00: If the stock trades above the strike price of $17.50 – the buyer of the call will exercise his option, and I will have to deliver the stocks or pay up the difference. So, although my loss is limited to $290 – the real loss is – the loss on my profits. Had I never written a call on Microsoft – I would have had the portfolio returning profits, but since I wrote that blasted call, all my potential profits have evaporated.
When does this strategy work?
This strategy works like charm when the stock remains flat, which means you don’t make a loss on your portfolio, and stand to gain the premium.
When does this strategy fail?
If the stock goes down substantially, and you need to sell the stock – then you will make a big loss. If you don’t need to sell the stock, then your losses are just notional losses.
When does this strategy suck?
If the stock goes up, and you don’t make any real losses, but you are not able to profit from the rise either because of the call, that would really suck. The whole point of buying a stock is to make money when it rises, and if you can’t make money, even when it rises – then that really sucks!
This strategy is really good for flat markets, if you are looking for something that will hedge your long positions in a stock then an – out-of-the-money put option may be much better. If you think that the stock is going to go up – then you are better off – leaving it alone.
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