The covered call is a strategy in options trading whereby call options are written against a holding of the underlying security.
Covered Call (OTM) construction
Long 100 shares
Sell 1 Call
Using the covered call option strategy, the investor gets to earn a premium writing calls while at the same time appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obliged to sell his shares.
However, the profit potential of covered call writing is limited as the investor has, in return for the premium, given up the chance to fully profit from a substantial rise in the price of the underlying asset.
Out-of-the-money covered call
This is a covered call strategy where the moderately bullish investor sells out-of-the-money calls against a holding of the underlying shares. The OTM covered call is a popular strategy as the investor gets to collect premium while being able to enjoy capital gains if the underlying stock rallies.
Limited profit potential
In addition to the premium received for writing the call, the OTM covered call strategy’s profit also includes gain if the underlying stock price rises, up to the strike price of the call option sold.
The formula for calculating maximum profit is given below:
- Max Profit = Premium received – Purchase Price of the Underlying + Strike Price of Short Call – Commissions Paid
- Max Profit Achieved when Price of Underlying>= strike Price of Short Call
Unlimited loss potential
Potential losses for this strategy can be very large and occurs when the price of the stock falls. However, this risk is no different than that which the typical stock owner is exposed to. In fact, the covered call writer’s loss is cushioned slightly by the premiums received for writing the calls.
The formula for calculating loss is given below:
- Maximum loss = Unlimited
- Loss Occurs When Price of Underlying < Purchase Price of Underlying – Premium received
- Loss = Purchase Price of Underlying – Price of Underlying – Max Profit + Commissions Paid
The stock price at which breakeven is achieved for the covered call (OTM) position can be calculated using the following formula:
- Breakeven Point = Purchase Price of Underlying – Premium Received