A Covered Call Concept

A Covered Call Concept

By Paul Price, Market Shadows

Everyone loves to get something for nothing. When covered calls  expire worthless that is exactly what happens. The writer (seller) received money for the call premium. An option that goes unused means the  seller ‘won’  without giving up anything (keeps premium, keeps underlying stock). 

Many people think that seeing short calls expire is the ‘best case’ result. They are wrong. Simply do the math.

We own 100 XYZ Corporation which trades at $45 per share.  The bid on the October $50 calls is $2. Selling one covered call contract brings in $2 x 100 shares = $200.

If XYZ finishes at $45, unchanged from its trade inception price, on expiration Friday:

We originally held 100 XYZ shares worth $4,500. At expiration we continue to own 100 XYZ shares, still worth $4,500. We also have the $200 from the call premium = $4,700 in total value. 

Had the underlying shares declined in price by more than the $2 per share premium we collected, our position would have less total value than when we started.

The call money received was 100% profit. Did that really represent the maximum possible gain? No.

Consider the result achieved if XYZ ends at $50 or higher on the option’s expiration date.

            

The call writer would be forced to deliver 100 XYZ shares when the option is exercised. The option owner would then pay $50 x 100 shares = $5,000.  The call seller would also keep the $200 from the call premium received.

Final position = No shares + $5,200 of cash.

Total Value = $5,200.

What would you rather have on the option expiration date… $4,700 in liquidation value or $5,200 in cash?

It does rankle when the underlying shock shoots well above the strike price. Call sellers capped their upside. They might not capture the full move.

Do not sell covered calls at strike prices lower than where you would be willing to part with your shares.

The ‘risks’ in covered call writing is the same one that occurs when you sell any stock. There is always a chance that those shares go higher afterwards.  Another risk is that the premium collected is insufficient to cover a drop in the share price.

The key concept is simple.

By definition...

Once you have sold covered calls, having the options exercised always represents the best case scenario.