Lesson 1: What is a covered call?
Covered Call writing is considered to be a very conservative investment strategy. You buy stock and sell someone the right to buy it from you some days in the future (at expiration day). Let's look at an example with the stock of XYZ:
XYZ is trading at 17$. You sell someone the right to purchase your XYZ stock for 17.50$ for the next few days (until expiration day) for a premium of 2$. Technically this means, that you're selling a call ( a purchase option for usually 100 shares) with a strike of 17.50 and a premium of 2$.
Let's do the math:
| Order | Cashflow |
|---|---|
| Buy 500 shares of XYZ for 17$ | - 8,500$ |
| Sell 5 call contracts (each for 100 shares) of XYZ at 17.50$ for 2$ | + 1,000$ |
Now let's look what happens at expiration day:
Scenario A:The stock remains unchanged at 17$. The calls you sold expire worthless, because why should somebody buy the for 17.50$ from you when he can buy at the market for just 17$ ?
| Order | Cashflow |
|---|---|
| You bought the 500 shares of XYZ for 17$ | - 8,500$ |
| You keep the premium of 500 * 2$ | + 1,000$ |
| You sell 500 shares of XYZ for 17$ | + 8,500$ |
You have made a return of 1,000$ withouth the stock moving a single tick! That's a return of 13.3 % for just some days holding stock of XYZ. But things get even better when we look at Scenario B...
Scenario B:The stock of XYZ has moved to 18$ at expiration day. You're being 'called' from the owner of the options you sold: you have to sell your XYZ stock to him for 17.50$ (the strike of the option you sold). Again, let's look at the return:
| Order | Cashflow |
|---|---|
| You bought the 500 shares of XYZ for 17$ | - 8,500$ |
| You keep the premium of 500 * 2$ | + 1,000$ |
| You sell 500 shares of XYZ for 17.50 | + 8,750$ |
This results in a profit of 1,250$ or 16.7%. But what if the stock price drops?
Scenario C:The shares of XYZ are dropping to 16$. What's your result at expiration?
| Order | Cashflow |
|---|---|
| You bought the 500 shares of XYZ for 17$ | - 8,500$ |
| You keep the premium of 500 * 2$ | + 1,000$ |
| You sell 500 shares of XYZ for 16$ (the option expires worthless) | + 8,000$ |
Adding up these figures we see a profit of 500$, although the stock price dropped! Actually, we're making profit as long as the stock remains above 15$!
Let's continue with lesson 2 and have a look at why 5% gain per month are enough...
If you have further questions feel free to write us at questions@coveredcalls.de.