This strategy involved being long the underlying stock and short a call option on the same stock. The long position in the underlying stock provides a cover, in case the buyer of the call option exercises his right and the stocks have to be delivered. If the trader buys the underlying instrument at the same time as he sells the call, the strategy is often called a “buy-write” strategy.
Covered Call Construction: Long 100 stocks + Short call option
Market Outlook: This strategy is useful if the investor has a neutral to slightly bullish market outlook.
Risk: Limited, but substantial. Risk arises from a fall in stock price.
Reward: Limited. Wring the call generates income from premium. If the stock price remains stable or increases, then the writer will be able to keep this premium as profit. In addition to the premium, the strategy’s profit also includes a paper gain if the underlying stock price rises, up to the strike price of the call option sold.
Break Even Point: Starting stock price minus premium received
An investor has 100 shares of ABC stock, valued at $10,000. He sells 1 call option contracts (in the US, 1 option contract covers 100 shares) for $300 with a strike price of $105. The payoff from the strategy can be shown as follows:
|Stock Price at Option Expiry||Position Profit / (Loss) at Expiry|