Covered Call Options Strategy Example

(assume we are in the month of September)

XYZ is trading at $17. You purchase 500 shares of XYZ for $17 a share.  You sell 5 XYZ October $17.50 calls for $2. (Essentially selling someone the right to purchase your XYZ stock for $17.50 a share in October for a premium of $2.) Technically this means, that you’re selling a call (a purchase option for usually 100 shares) with a strike of $17.50 and a premium of $2.

Let’s do the math:

Buy 500 shares of XYZ for 17$ – $8,500

Sell 5 call contracts (each for 100 shares) of XYZ at 17.50$ for 2$ +$1,000

Net investment is:   $7,500

Now lets look what happens at expiration day.

Scenario A: Stock unchanged

The stock remains unchanged at $17. The calls you sold expire worthless, because why should somebody buy the stock for $17.50 from you when he can buy at the market for just $17?

You keep the premium of 500 x $2 + $1,000

You sell 500 shares of XYZ for $17 + $8,500

With your initial investment of $7500, you have made a return of $1,000 or 13.3% without the stock moving a single tick!

Scenario B: Stock up slightly

The stock of XYZ has moved to $18 at expiration day. You’re being ‘called’ from the owner of the options you sold: you have to sell your XYZ stock to him for $17.50 (the strike of the option you sold). Again, let’s look at the return:

You keep the premium of 500 x $2 + $1,000

You sell 500 shares of XYZ for $17.50 + $8,750

With your initial investment of $7500, you have made a return of $1,250 or 16.7%.

Scenario C: Stock down slightly

The shares of XYZ are dropping to $16. What’s your result at expiration?

You keep the premium of 500 x $2 + $1,000

You sell 500 shares of XYZ for $16 (the option expires worthless) + $8,000

With your initial investment of $7500, you have made a return of $500 or 6.7% even though the stock price dropped! Actually, we’re making profit as long as the stock remains above $15.

Other Cases

The scenarios above are best case. Covered calls do not remove risk from your investment. You still hold the underlying security. Any downward movement in XYZ stock will still affect your bottom line. If the stock were to drop to $10, your return would be a loss of $3500 + options premium of $1000. Bringing your loss to $2500, or a loss of almost 30%! Covered calls do not protect you from loss.

If XYZ were to jump up significantly in price, you would also lose potential gains. In this same scenario if the price of XYZ were to climb to 25, your stock would get called at 17.50.

With your initial investment of $7500, you have made a return of $1,250 or 16.7%. BUT, you would also be missing out on the move from 17 to 25, or a potential gain of $4000 (53.3%).

Please Read

As always, consult an investment professional before buying or selling options. Never invest in something you don’t understand. Be sure to always read an investment’s prospectus or disclosure statement carefully. If you can’t understand the investment and how it will help you make money, ask a trusted financial professional for help. If you are still confused, you should think twice about investing.

Prior to buying or selling an option, investors must read a copy of the Characteristics & Risks of Standardized Options, also known as the options disclosure document (ODD). It explains the characteristics and risks of exchange traded options. A copy of this document and supplements can be found here.

Put strategies and examples to follow.