"Best trade ... over 666% Google bought Dec 05 $350 call in Sept for $8.80 sold for $62”
- Michelle R. - King George, VA
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Covered Calls - Page 1 of 2
In a covered call trade, you are buying the underlying stock shares and selling call options against it. This strategy is best implemented in a bullish to neutral market where a slow rise in the market price of the underlying stock is anticipated. This technique allows traders to handle moderate price declines because the call premium reduces the breakeven of the position. Since you are counting on the time decay of the short option to render the short call worthless, you do not want to sell a call more than 45 days out. However, since the profit on a covered call is limited to the premium received, the premium needs to be high enough to balance out the trade's risk. Table 5-1 illustrates the advantages a covered call offers in comparison to simply purchasing stock.
| Covered Call Strategy vs. Long Stock Strategy |
Market Scenario
Stock price increases: Call is exercised and the underlying stock shares are sold at the call's strike price
Stock price remains stable: Call expires worthless and the trader still owns the stock shares
Stock price decreases: Call expires worthless and the trader still owns the stock shares.
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Covered Call
Profits are limited to the premium received on the short call plus the profit made from the difference between the stock's price at initiation and the call strike price.
Profits are limited to the premium received on the short call.
The breakeven on the stock is lowered by the premium received on the short call.
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Long Stock
Profits may be garnered if the stock is sold at the higher price.
No profit is made.
Losses accumulate as the stock price declines below the initial price paid for the stock.
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Table 1-1: Covered Call Strategy vs. Long Stock Strategy
The key to a successful covered call lies in finding a stable market with slightly OTM options with less than 45 days till expiration with enough premium to make the trade worthwhile. The risk graph for this trade displays risks that are high, but limited with rewards that are capped by the short call strike price. Table 1-2 is used for this example.
| Price of WMT = 43.88 |
Call Strike Price
37.50
40
42.50
45
47.50
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October
6.60
4.10
1.80
0.35
0.05
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November
6.80
4.50
2.40
0.95
0.25
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Table 1-2: Wal-Mart Call Option Premiums (9/2006)
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