Covered Call Option Strategy

A covered call strategy is employed by investors seeking to generate income from their existing stock holdings. This strategy involves selling a call option against a stock position the investor already owns. By selling the call, the investor collects a premium, enhancing their portfolio's yield. The term "covered" refers to the fact that the investor's obligation to sell the underlying stock is backed by their long position in the shares.

In this strategy, the call option buyer gains the right to buy the shares at the strike price, while the investor who sells the call has the obligation to sell the shares if the option is exercised. Since the investor already holds the underlying stock, they are prepared to deliver the shares if required.

Example Scenario

Suppose an investor holds 100 shares of ZENTEK, a tech company, which they purchased at $20 per share. Expecting the stock to rise modestly but not significantly, the investor sells one ZENTEK call option at the $24 strike price with one month until expiration. The investor receives a $1.50 premium for selling the call.

Long 100 shares of ZENTEK purchased at $20
Sell 1 ZENTEK call option at the $24 strike price with 1 month until expiration for a $1.50 premium

Profit and Loss Analysis

Maximum Profit: The maximum gain is the difference between the call option’s strike price and the stock’s purchase price, plus the premium received:

Maximum Profit = (Strike Price - Stock Purchase Price + Premium) x 100 shares

Maximum Profit = ($24 - $20 + $1.50) x 100 = $550

Maximum Loss: The maximum loss occurs if ZENTEK stock price falls to zero. This is calculated as follows:

Maximum Loss = (Stock Purchase Price - Premium Received) x 100 shares

Maximum Loss = ($20 - $1.50) x 100 = $1,850

Breakeven Point: The breakeven point occurs when the stock price equals the purchase price minus the premium collected:

Breakeven Point = Stock Purchase Price - Premium

Breakeven Point = $20 - $1.50 = $18.50

Outcome Scenarios

If ZENTEK trades above $24 at expiration, the investor will realize the maximum gain of $550. The investor’s shares will be called away, resulting in a gain of $400 from stock appreciation plus the $150 premium collected.

If ZENTEK trades between $18.50 and $24 by expiration, the investor retains their shares and keeps the premium. Gains are maximized at $24 per share, but the investor still benefits from the premium in neutral or slightly bullish scenarios.

If ZENTEK trades below $18.50, the investor faces a loss. However, the $1.50 premium helps offset part of this downside. If ZENTEK’s value falls to zero, the investor’s total loss would be $1,850.

Key Considerations

Covered calls are well-suited for investors with a neutral to mildly bullish outlook. While this strategy generates income, it sacrifices significant upside potential if the stock rallies past the strike price. Conversely, the premium earned helps cushion losses in declining markets, but the investor remains exposed to the full downside risk of holding the stock itself. By carefully assessing market conditions and aligning the covered call strategy with their investment objectives, investors can effectively enhance returns on their portfolio.