Anatomy of a covered call

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Example of a covered call

Grasping the basics

John now knows that selling a covered call allows him to keep the premium received for income. He answered these 2 key questions “yes” – Am I willing to sell the stock if the price rises? Am I willing to own the stock if the price declines? John starts doing research to find a stock he is neutral to bullish on.

The following example shows how a 400-share covered call position might be created. Note that the stock price per share, the option price per-share, the number of shares, and the estimated commissions are used to calculate the actual dollar amount involved. Investors need to know the actual dollar amount so they can decide if the commitment is appropriate for them.

The information used to calculate the actual dollar amount is useful for other reasons as well. This information is needed to draw a profit-loss diagram. It is also necessary to calculate important aspects of a covered call position such as the maximum profit potential, the maximum risk potential and the breakeven point at expiration.

Profit-loss diagram of a covered call

The next step in analyzing a covered call position is drawing a profit-loss diagram, which shows the maximum profit potential, the maximum risk potential, and the breakeven point at expiration. Note that the diagram is drawn on a per-share basis and commissions are not included.

The horizontal axis in a profit-loss diagram shows a range of stock prices and the vertical axis shows profit or loss on a per-share basis.

In the diagram below, the hyphenated light-blue line that slopes from lower left to upper right shows just the stock position, which is purchased at $39.30 per share. The solid green line is the covered call position, which is the combination of the purchased stock and the sold call. Note that the covered call has limited profit potential which is achieved if the stock price is at or above the strike price of the call at expiration. In this example, the strike price is $40. Below the strike price, the profit is reduced as the stock price declines to the breakeven point. Below the breakeven point a covered call position has the full risk of stock ownership.

Maximum Profit Potential The maximum profit potential of a covered call is achieved if the stock price is at or above the strike price of the call at expiration.

The maximum profit potential is the sum of the call premium and the difference between the strike price and the stock price.

In this example, the maximum profit potential per share is: 0.90 + (40.00 – 39.30) = 1.60. Commissions are not included in this calculation for the sake of simplicity.
Breakeven Point at Expiration A covered call position breaks even at expiration at a stock price equal to the purchase price of the stock minus the call premium. In this example the breakeven point on a per-share basis is 39.30 – 0.90 = 38.40, commissions not included.
Maximum Risk Potential The maximum risk of a covered call equals purchasing stock at the breakeven point. In this example, the breakeven point is $38.40, not including commissions. Below this price the covered call writer has the full risk of stock ownership, so the maximum risk is $38.40 per share plus commissions.

“Effective selling price” if call is assigned

The term effective selling price refers to the total dollar amount received, including any option premium, for selling a stock. If a covered call is assigned, then the stock must be sold. For a covered call writer, the total dollar amount received is the sum of the strike price plus the option premium less commissions. In the example above, in which the 40 Call is sold for $0.90 per share, not including commissions, the effective selling price is $40.90. This is calculated by adding the strike price of 40 to the call premium of 0.90 for a total or 40.90 per share.

Determining the effective selling price is a simple calculation, and every covered call writer should calculate the effective selling price before entering a covered call position. They should then be sure that they are willing to sell the stock at this price.

Static return calculation

The static return is the estimated annualized net profit of a covered call, assuming the stock price remains constant until expiration and the call expires. For simplicity, returns are generally calculated on a per-share basis. To calculate a static rate of return, one needs to know five things:

  • purchase price of the stock
  • strike price of the call
  • price of the call
  • days to option expiration, and
  • amount of dividends, if any.

In the example above, the stock was purchased at $39.30 per share, the 40 Call was sold for $0.90 per share, there were 60 days to expiration, and there were no dividends. Assuming no commissions, the static rate of return is calculated as follows:

Static Rate of Return = Income / Investment × Time Factor

Static Rate of Return = (Call + Dividend) / Stock Price × (360 days per year/60 days to expiration)

Static Rate of Return = (0.90 + 0) / 39.30 × (360 / 60)

Static Rate of Return = .137 = 13.7%

Note: Since the time period of a covered call is usually less than 12 months, the return calculations assume that covered calls can be sold repeatedly in identical market conditions over the course of a year, thus the “annual” rate of return. There is no assurance, however, that this is possible. In many cases, in fact, it is not possible to repeatedly sell covered calls in identical or even similar market conditions. For this reason annual rate of return calculations must be interpreted very carefully.

If-called return calculation

The if-called return is the estimated annualized net profit of a covered call, assuming the stock price is above the strike price at expiration and that the stock is sold at expiration when the call is assigned. For simplicity, returns are generally calculated on a per-share basis. To calculate an if-called rate of return, one needs to know five things:

  • purchase price of the stock
  • strike price of the call
  • price of the call
  • days to option expiration, and
  • amount of dividends, if any.

In the example above, the stock was purchased at $39.30 per share, the 40 Call was sold for $0.90 per share, there were 60 days to expiration, and there were no dividends. Assuming no commissions, the if-called rate of return is calculated as follows:

If-Called Rate of Return = (Income + Gain) / Investment × Time Factor

If-Called Rate of Return = (Call + Dividend) + (Strike – Stock Price) / Stock Price × (360 days per year/60 days to expiration)

If-Called Rate of Return = (0.90 + 0) + (40.00 – 39.30) / 39.30 × (360 / 60)

If-Called Rate of Return = .244 = 24.4%

Note: Since the time period of a covered call is usually less than 12 months, the return calculations assume that covered calls can be sold repeatedly in identical market conditions over the course of a year, thus the “annual” rate of return. There is no assurance, however, that this is possible. In many cases, in fact, it is not possible to repeatedly sell covered calls in identical or even similar market conditions. For this reason annual rate of return calculations must be interpreted very carefully.

Key takeaways

A covered call, which is also known as a “buy write,” is a two-part strategy in which stock is purchased and calls are sold on a share-for-share basis.

Losses occur in covered calls if the stock price declines below the breakeven point. There is also an opportunity risk if the stock price rises above the effective selling price of the covered call.

Investors should calculate the static and if-called rates of return before using a covered call.

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