Free 7-day Trial
All Articles and Columns »

A Covered Call Concept

July 24, 2013 | About:
Everyone loves to get something for nothing. When covered calls end up expiring worthless that is exactly what happens. The writer (seller) received money for the call premium. If the option goes unused then the call seller "won" without giving up anything.

Many people think that seeing short calls expire is the "best case" result. They are wrong. To understand why, simply do the math.

We own 100 XYZ Corporation which now trades at $45 per share. The bid on the October $50 calls is $2. Sell one covered call contract at that price and collect $2 x 100 shares = $200.

If XYZ finishes unchanged at $45 on expiration Friday:

1889699438.jpg

We started with 100 XYZ shares are worth $4,500. On expiration date we continue to hold the original 100 XYZ shares, still worth $4,500, plus the $200 call premium = $4,700 in total value.

Had the underlying shares declined in price by greater than $2 per share our position would have less total value than we started with.

Since the call option expired, the option premium received was 100% profit. Did that really represent the maximum possible gain? No.

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

1901333497.jpg

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

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

Total Value = $5,200.

Which would you rather have on the option expiration date… $4,700 or $5,200?

It does rankle if the underlying shock shoots well above the chosen strike price. Call sellers have capped their upside. They will miss out on pocketing the full move. Do not sell covered calls at strike prices lower than where you would be willing to part with your shares.

The "risk" in covered call writing is exactly the same as what you take whenever you sell any stock. There is always a chance that those shares could go higher afterwards.

The key concept is simple.

Once you have sold covered calls, seeing the option exercised always delivers your best-case result.

See more Value Investing ideas here http://marketshadows.com/value-investing

About the author:

Dr. Paul Price
http://www.RealMoneyPro.com
http://www.MarketShadows.com
http://www.TalkMarkets.com

Visit Dr. Paul Price's Website


Rating: 4.5/5 (4 votes)

Comments

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK
Hide