Covered Call Option Strategy
A covered call option strategy is when an investor sells a call option while holding the underlying stock position long. Investors with an investment objective of income utilize a covered call option strategy to collect premiums from the sale of call options. A covered call option strategy requires a moderate level of risk tolerance.
The maximum potential loss is the entire value of the stock less the premium received from the option sale. Covered calls limit the upside profit potential of the stock during the duration of the option. This is because the option seller has the obligation to sell shares of stock if the buyer of the option exercises the option.
Therefore, an investor who seeks a covered call strategy may have their shares sold at the strike price and may no longer participate in any future stock price increases. An investor who has a neutral to slightly bullish outlook that does not anticipate the stock price to exceed beyond a certain price point utilizes a covered call option strategy to increase their return.
Let’s See an Example
An investor anticipates that stock price of RAWR will go up in the short term but not beyond a certain price. He purchases 100 shares of RAWR at $10. In addition, he sells a call option of RAWR at the $14 strike price with 1 month until the expiration for a premium of $2.
• Long 100 shares of RAWR stock bought at $10
• Sell 1 RAWR call option at the $14 strike price with 1 month until expiration date for a premium of $2
The maximum profit is the difference between the strike price of the option and price at which he purchased the stock plus the premium collected from the option sale. This is calculated as follows:
Maximum Profit per Option = (Strike Price of Option - Stock Purchase Price + Premium) x 100 shares
$600 = ($14- $10 + $2) x 100 shares
The maximum loss is the stock purchase price less the premium received multiplied by 100 shares. This is calculated as follows:
Maximum Loss per Option = (Stock Purchase Price- Premium) x 100 shares
$800 = ($10 - $2) x 100 shares
The breakeven point is the purchase price of the stock less the premium received. This is calculated as follows:
Breakeven Price = (Short Call Option Strike Price - Premium)
$8= $10-$2
The profit and loss of the covered call option strategy until expiration date is depicted in the chart below.
The chart shows the potential profit and loss on the y-axis versus the corresponding stock price in the x-axis until expiration date.
If RAWR trades up to $14 and beyond, the investor will make $600, which is made up of $400 from the stock price appreciation plus the $200 from the sale of the call option. Conversely, the maximum potential downside risk is $800. This is comprised of the $1,000 loss if the stock price goes to $0 less the $200 premium made from selling the call.
If the price of RAWR ever exceeds the price of $14 during the life of the option contract, the investor could potentially be assigned and be obligated to sell his 100 shares. While the investor realizes the maximum profit in this situation, the 100 shares are no longer held long. If, however, the price remains between $8 and $14 up until the expiration date, the investor will receive a profit greater than had he just held the stock and not sold a call. In this way investors can make a greater return selling covered calls in a rising bull market.
The potential downside risk is if RAWR ends up below $8 by the time the option expires. In this scenario the investor will be left with a loss. However, the investor offsets a portion of the loss from the stock decline with the premium received from selling the call option.