Option Strategies - Long Stock Short Calls / Covered Calls

An investor who is long stock can receive some partial downside protection and generate some additional income by selling calls against the stock they own. The investor will receive downside protection or will hedge their position by the amount of the premium received from the sale of the calls. While the investor will receive partial downside protection, they will also give up any appreciation potential above the call’s strike price. An investor who is going to establish a covered call position must determine:

  • Their Breakeven
  • Their Maximum Gain
  • Their Maximum Loss

Breakeven Long Stock Short Calls

By selling the calls, the investor has lowered their breakeven on the stock by the amount of the premium received from the sale of the calls. To determine the investor’s breakeven in this case, the price to which the stock can fall, use the following formula:

Purchase Price of the Stock – Premium Received

Example:

An investor establishes the following position:

Long 100 ABC at 65

Short 1 ABC June 65 call at 4

Using the formula above, we get:

65 – 4 = 61

The stock price in this case can fall to $61 and the investor will still breakeven.

Maximum Gain Long Stock Short Calls

Because the investor has sold call options on the stock that they own, they have limited the amount of their gain. Any appreciation of the stock beyond the call’s strike price belongs to the investor who purchased the call.

To determine an investor’s maximum gain on a long stock short call position, use the following formula:

Maximum Gain = Strike Price – Breakeven

Let’s use the same example to determine the investor’s maximum gain.

Example:

An investor establishes the following position:

Long 100 ABC at 65

Short 1 ABC June 65 call at 4

Using the formula above, we get:

65 - 61 = $4

The investor’s maximum gain is $4 per share or $400 for the entire position. Notice that because the purchase price of the stock and the strike price of the call are the same, the investor’s maximum gain is equal to the amount of the premium received on the sale of the call.

Let’s look at an example where the strike price and the purchase price for the stock are different.

Example:

An investor establishes the following position:

Long 100 ABC at 65

Short 1 ABC June 70 call at 2

The investor will breakeven at $63 found by subtracting the premium received from the investor’s purchase price for the stock. To determine their maximum gain, we subtract the breakeven from the strike price and we get:

70 - 63 = 7

The investor’s maximum gain is $7 per share or $700 for the entire position.

Maximum Loss Long Stock Short Calls

An investor who has sold cover calls has only received partial downside protection in the amount of the premium received. As a result, the investor is still subject to a significant loss in the event of an extreme downside move in the stock price. To determine an investor’s maximum loss when they are long stock and short calls, use the following formula:

Maximum Loss = Breakeven – 0

Said another way, an investor is subject to a loss equal to their breakeven price per share.

Using the same example, we get:

Example:

An investor establishes the following position:

Long 100 ABC at 65

Short 1 ABC June 70 call at 2

The investor will breakeven at $63, found by subtracting the premium received from the investor’s purchase price for the stock. To determine their maximum loss, we only need to look at the breakeven and we get a maximum loss of $63 per share or $6,300 for the entire position. The investor will realize their maximum loss if the stock goes to zero.

Ratio Call Writing

An investor who is long stock may elect to write calls covering more shares than the investor owns. As a result, the investor will have written both covered calls and uncovered calls. This is known as ratio writing. For example, an investor may elect to write calls in a 2:1, 3:1 or 4:1 ratio. The investor will realize the greatest gain if the stock is stable and the options expire. The investor will have an unlimited potential loss as a result of the naked or uncovered calls.

TAKE NOTE!

The investor’s account must be approved for uncovered options prior to executing any ratio writing strategy.

Series 4 Exam

Short Stock Long Calls
Related Articles
  1. Professionals

    Series 99

    FINRA/NASAA Series 99 Exam Guide
  2. Professionals

    Series 24

    FINRA/NASAA Series 24 Exam Guide
  3. Personal Finance

    Careers: Equity Research Vs. Investment Banking

    Equity research is sometimes viewed as the unglamorous, lower-paid cousin to investment banking. In this article, we compare the two careers.
  4. Investing

    7 Reasons You Will Make a Good Investment Banker

    Many seek at the door of investment banking, but few can enter. Possessing these seven traits will help you land a job and succeed in investment banking.
  5. Investing

    7 Reasons Investment Banking Is Not for You

    Even if you possess the education, experience and enthusiasm to land a coveted investment banking gig, here are seven reasons to find another career.
  6. Term

    Understanding the Maintenance Margin

    A maintenance margin is the minimum amount of equity that must be kept in a margin account.
  7. Economics

    Explaining Kurtosis

    Kurtosis describes the distribution of data around an average.
  8. Personal Finance

    The 10 Must Watch Movies For Finance Professionals

    Finance makes for great cinema; here are 10 of the best offerings by Hollywood on the subject.
  9. Professionals

    Career Advice: Management Consulting Vs. Investment Banking

    Compare the career opportunities available in management consulting and investment banking. Learn about salaries, skills needed and work-life balance.
  10. Professionals

    Career Advice: Management Consulting Vs. Law

    Compare the career opportunities between management and law using such criteria as skills needed, starting salary and work-life balance.
RELATED TERMS
  1. Series 6

    A securities license entitling the holder to register as a limited ...
  2. Clowngrade

    An upgrade or downgrade of a security for reasons considered ...
  3. Advanced Diploma In Insurance

    A qualification earned by insurance professionals and conferred ...
  4. Associate In Personal Insurance ...

    A designation earned by professionals looking for training in ...
  5. Fintech

    Fintech is a portmanteau of financial technology that describes ...
  6. Associate In Reinsurance (ARe)

    A designation earned by insurance professionals looking for reinsurance ...
RELATED FAQS
  1. How does FINRA differ from the SEC?

    With all the financial organizations out there, knowing what they all do can be as complicated as knowing where to invest. ... Read Full Answer >>
  2. I have a CFA designation. Do I qualify for any exemptions from FINRA licensing exams?

    Unfortunately, a CFA charter does not qualify you for any FINRA exam exemptions. Read Full Answer >>
  3. How can I find out if my employer is a member of FINRA?

    To find out if your employer is a member of the Financial Industry Regulatory Authority or FINRA (previously the National ... Read Full Answer >>
  4. Am I qualified once I complete my FINRA certification exam?

    Even if you have completed your Financial Industry Regulatory Authority or FINRA (previously the National Association of ... Read Full Answer >>
  5. How does a broker decide which customers are eligible to open a margin account?

    Brokers have the sole discretion to determine which customers may open margin accounts with them, although there are regulations ... Read Full Answer >>
  6. How can an investment banker switch to a career in corporate finance?

    It's pretty easy for an investment banker to switch to a career in corporate finance. The career skills are easily transferable, ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!