BREAKING DOWN ‘Covered Call’
The outlook of a covered call strategy is for a slight increase in the underlying stock price for the life of the short call option. Consequently, this strategy is not useful for a very bullish investor. A covered call serves as a short-term small hedge on a long stock position and allows investors to earn a credit. However, the investor forfeits the potential of the stock’s potential increase and is obligated to provide 100 shares to the buyer of the option if it is exercised.
Maximum Profit and Loss
The maximum profit of a covered call is equivalent to the strike price of the short call option less the purchase price of the underlying stock plus the premium received. Conversely, the maximum loss is equivalent to the purchase price of the underlying stock less the premium received.
Covered Call Example
For example, let’s say that you own shares of the hypothetical TSJ Sports Conglomerate and like its long-term prospects as well as its share price but feel in the shorter term the stock will likely trade relatively flat, perhaps within a few dollars of its current price of, say, $25. If you sell a call option on TSJ with a strike price of $26, you earn the premium from the option sale but cap your upside. One of three scenarios is going to play out:
a) TSJ shares trade flat (below the $26 strike price) – the option will expire worthless and you keep the premium from the option. In this case, by using the buy-write strategy you have successfully outperformed the stock.
b) TSJ shares fall – the option expires worthless, you keep the premium, and again you outperform the stock.
c) TSJ shares rise above $26 – the option is exercised, and your upside is capped at $26, plus the option premium. In this case, if the stock price goes higher than $26, plus the premium, your buy-write strategy has underperformed the TSJ shares.
To know more about covered calls and how to use them, read The Basics Of Covered Calls and Cut Down Option Risk With Covered Calls.