{"id":15759,"date":"2023-01-22T10:40:00","date_gmt":"2023-01-22T10:40:00","guid":{"rendered":"https:\/\/businessyield.com\/?p=15759"},"modified":"2023-01-22T21:40:49","modified_gmt":"2023-01-22T21:40:49","slug":"covered-call","status":"publish","type":"post","link":"https:\/\/businessyield.com\/business-strategies\/covered-call\/","title":{"rendered":"COVERED CALL Explained: Understanding Covered call Formula With Examples","gt_translate_keys":[{"key":"rendered","format":"text"}]},"content":{"rendered":"\n

A covered call is a financial transaction for investors. As a financial investor, you must have heard of the covered call. It is a crucial topic in the world of finance. This article will serve as a guide in discussing selling a covered call in money; it will also show you some examples and formulas for the covered call.<\/p>\n\n\n\n

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Photo Credit: Investopedia<\/figcaption><\/figure>\n\n\n\n

As we are about to dive into this topic, sit, relax, learn and enjoy.<\/p>\n\n\n\n

Covered Call<\/strong><\/span><\/h2>\n\n\n\n

A covered call is a risk management and an options strategy. It includes holding a lasting position in the underlying asset, such as stock. It also sells a call option on the underlying asset. Investors commonly employ the strategy who believe that the underlying asset will undergo only insignificant price changes.<\/p>\n\n\n\n

Additionally, A covered call relates to a financial transaction in which the investor selling call options owns an equivalent amount of the underlying security. To do this, an investor holding a long position in an asset will write (sell) call options on that same asset to produce an income stream. <\/p>\n\n\n\n

However, the investor’s long position in the asset is the “cover”. It shows that the seller can deliver the shares if the call option buyer decides to operate. <\/p>\n\n\n\n

Furthermore, if the investor simultaneously buys a stock and writes call options against that stock position, it is called a “buy-write” transaction.<\/p>\n\n\n\n

Covered Call Example<\/strong><\/span><\/h2>\n\n\n\n

An investor owns shares of a hypothetical company WNE. They like its long-term outlooks as well as its share price. However, they feel that the stock will likely trade relatively low in the shorter term, perhaps within a couple of dollars of its current price of $250.<\/p>\n\n\n\n

If they sell a call option on WNE with a strike price of $270, they earn the bonus from the option sale but, for the duration of the option, cap their upside on the stock to $270. Assume the premium they receive for writing a three-month call option is $0.75 ($75 per contract or 100 shares).<\/p>\n\n\n\n

One of two cases will play out:<\/p>\n\n\n\n

  • WNE shares trade below the $270 strike price. The choice will expire worthlessly, and the investor will keep the premium from the option. In this case, by using the buy-write tactic, they have successfully outperformed the stock. They still own the stock but have an extra $750 in their pocket, fewer fees.<\/li>
  • WNE shares rise above $270. The choice is performed, and the upside in the stock is capped at $270. If the price goes above $270.750 (strike price plus premium), the investor would have been better off holding it. However, if they planned to sell at $270 anyway, writing the call option gave them an extra $0.750 per share.<\/li><\/ul>\n\n\n\n

    Selling A Covered Call<\/strong><\/span><\/h2>\n\n\n\n

    When an investor sells a covered call, he gets paid in exchange for giving up a portion of future upside. For example, let’s imagine you bought WNE stock for $500 per share, believing it will rise to $600 within one year. You’re also ready to sell at $550 within six months, giving up further upside while taking a short-term profit. In this case, selling a covered call on the position might be an attractive tactic.<\/p>\n\n\n\n

    The stock’s option chain shows that selling a $550 six-month call option will cost the buyer a $40 per share premium. You could sell that option against your shares, which you purchased at $500, and wish to sell at $600 within a year.<\/p>\n\n\n\n

    Also, writing this covered call generates an obligation to sell the shares at $550 within six months if the underlying price reaches that level. You get to keep the $40 in premium plus the $550 from the share sale for a total of $590, or an 18% return over six months.<\/p>\n\n\n\n

    On the other hand, you’ll incur a $100 loss on the original position if the stock falls to $400. However, you get to keep the $40 premium from the call option’s sale, lowering the total loss from $100 to $600 per share.<\/p>\n\n\n\n

    Bullish Scenario: Shares rise to $600, and the option is exercised<\/strong><\/span><\/h3>\n\n\n\n

    January 1<\/p>\n\n\n\n

    Buy XYZ shares at $500<\/p>\n\n\n\n

    January 1<\/p>\n\n\n\n

    Sell XYZ call option for $40 – expires on June 30, exercisable at $550<\/p>\n\n\n\n

    June 30<\/p>\n\n\n\n

    Stock closes at $600 – the choice is exercised because it is above $550, and you receive $550 for your shares.<\/p>\n\n\n\n

    July 1<\/p>\n\n\n\n

    PROFIT: $50 capital gain + $40 premium collected from sale of the option = $90 per share or 18%<\/p>\n\n\n\n

    Bearish Scenario: Shares drop to $400, and the option is not exercised<\/strong><\/span><\/h3>\n\n\n\n

    January 1<\/p>\n\n\n\n

    Buy XYZ shares at $500<\/p>\n\n\n\n

    January 1<\/p>\n\n\n\n

    Sell XYZ call option for $40 – expires on June 30, exercisable at $550<\/p>\n\n\n\n

    June 30<\/p>\n\n\n\n

    Stock closes at $400 – the choice is not exercised, and it expires worthless because the stock is below the strike price. (the option buyer has no incentive to pay $550\/share when they can purchase the stock at $400)<\/p>\n\n\n\n

    July 1<\/p>\n\n\n\n

    LOSS: $100 share loss – $40 premium collected from sale of the option = $60 or -12%. <\/p>\n\n\n\n

    Now that we have known everything about that, let us discuss selling a covered call in the money. Shall we?<\/p>\n\n\n\n

    Selling A Covered Call In The Money <\/strong><\/span><\/h2>\n\n\n\n

    Let’s say that Jason buys 1000 shares of stock in Income Streams, Inc, for $1000. This will be the underlying stock against which he sells call options for some extra income.<\/p>\n\n\n\n

    It’s a quality stock. However, based on the stock’s chart, he thinks the stock has a reasonable probability of dropping in value over the short term. This is because it’s at the top of its’ current trading range.<\/p>\n\n\n\n

    With that in mind, he decides to sell a call option with a $990 strike for $20 instead of a call option with a $1000 strike for $1.500 against her Income Streams, Inc. shares.<\/p>\n\n\n\n

    Here’s how Jason looks at it.<\/p>\n\n\n\n

    Suppose the stock drops to $970 by the option’s expiration date. The choice won’t be exercised. He will keep the stock and sell another call option soon at a reasonable time. Hence anticipating the stock will move back toward the high end of its’ trading range within a week or two based on its recent trends.<\/p>\n\n\n\n

    Jason already made an excellent $20 per contract for the call option he sold.<\/p>\n\n\n\n

    Jason’s example gives you a basic and clear idea of why a covered call seller may choose an in-the-money-covered call strategy. <\/p>\n\n\n\n

    Having said all that, let us take a look at the covered call formula.<\/p>\n\n\n\n

    Covered Call Formular<\/strong><\/h2>\n\n\n\n

    The covered call formula can be calculated as:<\/p>\n\n\n\n

    CCV= PU- MAX(0 or PU – EP)<\/p>\n\n\n\n

    Where,<\/p>\n\n\n\n

    CCV: covered call value<\/p>\n\n\n\n

    PU: Price of the underlying asset at the exercise date<\/p>\n\n\n\n

    EP: Exercise Price<\/p>\n\n\n\n

    Then the next thing to calculate is the profit from the covered call.<\/p>\n\n\n\n

    Calculating the value is an extension of what was calculated above.<\/p>\n\n\n\n

    Profit = CCV- PS+ Premium<\/p>\n\n\n\n

    Where,<\/p>\n\n\n\n

    PS is the price of the asset at the start of the tactic. while<\/p>\n\n\n\n

    Premium is the price paid by the buyer to the covered call seller(writer<\/p>\n\n\n\n

    Conclusion<\/span><\/h3>\n\n\n\n

    In conclusion, the Covered call is one financial transaction that investors should treat with crucial attention. Knowing the covered call formula and examples is also an advantage.<\/p>\n\n\n\n

    Covered Call FAQ<\/h2>\n\n\n\t\t\n\t\t\t\t

    Can you lose money on a covered call?<\/h2>\t\t\t\t
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    You can only lose the amount you paid for the asset if you use a covered call strategy. Short call option premium received plus the strike price of the short call option can only be used to offset the purchase price reduction in a covered call strategy.<\/p>\n\n\t\t\t<\/div>\n\t\t<\/div>\n\t\t<\/section>\n\t\t\t\t\n\t\t\t\t

    What are covered calls example?<\/h2>\t\t\t\t
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    An investor owns shares of a hypothetical company WNE. They like its long-term outlooks as well as its share price. However, they feel that the stock will likely trade relatively low in the shorter term, perhaps within a couple of dollars of its current price of $250.<\/p>\n\n\t\t\t<\/div>\n\t\t<\/div>\n\t\t<\/section>\n\t\t\n