Understanding Covered Calls

A covered call is an options strategy where an investor holds a long position in an asset (e.g., 100 shares of stock) and sells (writes) call options on that same asset. This strategy is used to generate income from the option premium, while limiting potential upside gains.

It's called "covered" because the investor already owns the underlying shares, which act as collateral if the option is exercised.

Covered Call Profit/Loss Calculation

The profit or loss from a covered call depends on the stock price at expiration relative to the strike price and the premium received.

Here are the key calculations:

• Maximum Profit: Occurs if the stock price is at or above the strike price at expiration.

Maximum Profit = (Strike Price - Purchase Price of Stock) + Premium Received

• Maximum Loss: Occurs if the stock price falls to zero.

Maximum Loss = Purchase Price of Stock - Premium Received

• Break-even Point: The stock price at which the strategy neither makes a profit nor incurs a loss.

Break-even Point = Purchase Price of Stock - Premium Received

Example: Calculating Covered Call Profit/Loss

Let's walk through an example to understand how these calculations work.

Scenario:

• You buy 100 shares of XYZ stock at $50 per share.
• You sell 1 call option contract (covering 100 shares) with a strike price of $55 for a premium of $2.00 per share ($200 total).

Calculations:

1. Purchase Price of Stock: $50 per share
2. Strike Price: $55 per share
3. Premium Received: $2.00 per share

Now, let's calculate the profit/loss scenarios:

1. Maximum Profit:
   If XYZ stock is at or above $55 at expiration, your shares will be called away at $55. Your profit is:
   ($55 Strike Price - $50 Purchase Price) + $2.00 Premium = $7.00 per share
   Total Max Profit = $7.00 * 100 shares = $700

1. Maximum Loss:
   If XYZ stock falls to $0, you lose the entire value of your stock, offset by the premium received.
   $50 Purchase Price - $2.00 Premium = $48.00 per share
   Total Max Loss = $48.00 * 100 shares = $4,800

1. Break-even Point:
   The stock price at which you neither gain nor lose money.
   $50 Purchase Price - $2.00 Premium = $48.00 per share

This example illustrates how a covered call can generate income but also caps your potential upside and exposes you to downside risk if the stock price drops significantly.