Question

What type of trader might use covered calls? Give a specific example.

Answer 1

Before we answer this question, let's understand what a covered call is?

As a covered call writer or seller, you sell the right (but not the obligation) to buy a particular underlying security which you own, at a predetermined price on or before a predetermined time. Please note that it's a covered call because you already own the underlying security with you. You don't have to buy the security from the market in case buyer or owner of the call option exercises the call option.

Let's now look at the question.

What type of trader might use covered calls?

Following type of traders might use / write covered calls:

1. Those who have neutral or slightly bullish stand on a particular stock
2. Those who want to generate an additional investment income without selling the stock for the time being
3. Those traders who want to protect their downside risk but only to a limited extent
4. Those who want to take calculated risks - you get to decide the strike price and also the time to maturity

Example:

Consider an investor who has purchased 100 shares of Alpha at a share price of $ 30. he believes that stock price may go up marginally over the near term. So he writes a covered call option with strike price of $ 35 maturing in three months' time. He writes this call for a premium of $ 2. Examine the payoff of this strategy to this investor under various scenarios. Assume no transaction charges, securities transaction taxes etc.

Scenario 1: At the time of expiry i.e. 3 months from now, the stock price is $ 36

The writer of the call option would have got the premium for call of $ 2 at the time of selling the option. Since stock price is greater than strike price, the buyer of the option will exercise the stock. The write of the call will have to deliver the stock to the buyer and thus he loses an opportunity to make a gain of $ 36 - $ 30 = $ 6 per share. However a part of this is already recovered through the premium of $ 2 he received on sale of covered call option.

Scenario 2: At the expiry i.e. 3 months from now, the stock price is $ 28

The investor will incur an unrealized loss of $ 30 - $ 28 = $ 2 per share. However the same is offset by the $ 2 per call he earned by selling the covered call option.

Scenario 3: At the expiry i.e. 3 months from now, the stock price is at $ 30.

The investor has already made a gain of $ 2 per share on sale of the call option.

Thus an investor adds to his immediate income, adds to his upside potential to some extent and limits his downside risk to some extent by writing a covered call option.