A covered call is derived when call options are written against a holding of the underlying security.
Covered Call (OTM) construction
Long 100 shares
Sell 1 Call
With the covered call option strategy, earn a premium writing calls while at the same time appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless an exercise notice is assigned on the written call.
However, the profit potential of covered call writing is limited to the premium, having given up the chance to fully profit from a substantial rise in the price of the underlying.
Out-of-the-money covered call
This is a 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 used to collect premium whilst enjoying capital gains should 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, above the strike price of the call option sold.
- Max Profit = Premium received – Purchase Price of the Underlying + Strike Price of Short Call – Commissions Paid
- Max Profit is achieved when Price of Underlying is more than 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 similar to that which the stock owner is exposed to. In fact, the covered call writer's loss is buffered by the premiums received for writing the calls.
- Maximum loss = Unlimited
- Loss Occurs When Price of Underlying is less than Purchase Price of Underlying – Premium received
- Loss = Purchase Price of Underlying – Price of Underlying – Max Profit + Commissions Paid
- Breakeven Point = Purchase Price of Underlying – Premium Received