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Duration: 1:20

Level: Intermediate

An investor might be bullish on the outlook for a stock, but may wish to generate income by standing ready to have the stock called away using the covered call strategy.

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Study Notes:

A covered call would be considered by someone who would like to derive additional income from a long stock position.  A covered call allows the investor to hold a long equity position while simultaneously receiving the premium from selling an equal amount of call options against it. The covered call writer is bullish on the stock’s long-term potential but is willing to forego a stock’s upside above the strike during the life of the option in order to receive the proceeds of the call premium.  The covered call writer benefits from time decay, from a reduction in volatility and if the stock increases its dividend before expiration.  It should be noted that the combined position has a similar profile to that of a short put.  The covered call writer remains exposed to any downside in the underlying shares, meaning his loss potential is substantial.

Market Outlook- Mildly Bullish

Volatility View- Premium decreases

Time Erosion- Helps

Dividends- Premium increases

Interest Rate- Premium decreases

Profit Potential- Limited to gains from equity to the strike price, plus premium received from the sale of call option

Loss Potential- Limited to downside movement in the equity minus the premium received from the sale of call option

Components Long equity, short call option

Covered Call Example:

  • Underlying XYZ stock price: $50.00
  • Call strike price: 55.00
  • Call option premium: $1.75
  • Days to expiration: 90
  • Breakeven: 50.00-$1.75=$48.25 (underlying share purchase price minus premium received for call option)

Profit potential: Limited to the gain on the underlying share price until the strike price is reached, plus the premium received from the sale of the call option. Thereafter, gains from the stock are equally offset by the rising cost of the short call option.

Potential profit: @$54.00 – The sum of the gain on the stock ($54.00 – $50.00 = $4.00) plus the premium of $1.75 received from the sale of the call for a total of $5.75.

@$55.00 – The strike price marks the maximum potential profit from the strategy. The gain on the stock of $5.00 is added to the premium of $1.75 received from the sale of the call. At the strike price, the call has zero extrinsic value at expiration. The investor sold it initially for $1.75, and so retains the entire premium. At any point above the strike price at expiration, what the investor gains from the stock, he loses penny-for-penny on the short call option.

@$44.00 – At any price below the call strike the option expires worthless and the investor keeps the entire premium. However, the stock has fallen by $6.00 per share. That loss is partially offset by the premium received from the sale of the call option. So the overall loss at $44.00 per share is $6.00 – $1.75 or $4.25.

Maximum loss: Limited by the fact that the stock can only fall to zero. However, the investor starts to lose money at the share purchase price less the premium received ($50.00 minus $1.75 = $48.25) and continues to lose penny-for-penny as the share price declines further.

Underlying Stock  $   50.00 Underlying Stock Call P&L Stock P&L Total
Call Strike  $   55.00  $                 10.00  $          175.00  $(4,000.00)  $(3,825.00)
Premium  $     1.75  $                 20.00  $          175.00  $(3,000.00)  $(2,825.00)
 $                 25.00  $          175.00  $(2,500.00)  $(2,325.00)
 $                 30.00  $          175.00  $(2,000.00)  $(1,825.00)
 $                 35.00  $          175.00  $(1,500.00)  $(1,325.00)
 $                 40.00  $          175.00  $(1,000.00)  $    (825.00)
 $                 45.00  $          175.00  $    (500.00)  $    (325.00)
 $                 50.00  $          175.00  $              –  $     175.00
 $                 55.00  $          175.00  $     500.00  $     675.00
 $                 60.00  $        (500.00)  $  1,000.00  $     500.00
 $                 70.00  $     (1,500.00)  $  2,000.00  $     500.00
 $                 80.00  $     (2,500.00)  $  3,000.00  $     500.00


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Disclosure: Interactive Brokers

The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

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