Covered Call

Covered call, also called ‘buy-write strategy’, involves holding a long position in an underlying asset and selling a call option for the same. The long position in the underlying asset is said to act as the "cover" for the option, as the shares can be delivered to the buyer of the call if the buyer decides to exercise the option. It is used by the traders who have a bullish to neutral view for the returns on that underlying. The primary motive in this strategy is to earn the premium by selling the call option hoping that the stock prices wouldn’t go down.

The figure above shows the payoff for a covered call as a combination of the long stock and the short call with a strike price (K).

Example:

Let us assume that a trader is long 1 share of ABC stock worth $20, and sells a call on the same with a strike of $23 for $2.

Case 1: If the stock goes up to $20<=P<$23, the call expires worthless and trader earns a net profit of $2 plus the gain in stock price; which is equal to ($2 + $23 - P). The profit ranges from $2 to $5.

Case 2: If the Stock price goes up to P >= $23, the buyer of the call will exercise the call and buy the stock from a trader for $23; hence the net profit for the trader will be ($23 -$20 + $2) = $5. The profit will be capped at $5.

Case 3: If the stock price goes down to P<$20, then the call option expires worthless, the trader now has $2 and the loss from the stock position is equal to ($2 + P - $20). Profit/Loss range from loss of $18 to gain of $2.