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

    Tips For Series 7 Options Questions

    We'll show you how to ace the largest and most difficult section of this exam.
  2. Options & Futures

    Trade The Covered Call - Without The Stock

    The standard covered call can be used to hedge positions or generate income. This calendar spread may do so more effectively.
  3. Options & Futures

    Solving Mixed Options Problems On The Series 7

    Learn to ace the questions that involve both options contracts and stock positions.
  4. Options & Futures

    Writing Covered Calls On Dividend Stocks

    Writing covered calls on stocks that pay above-average dividends is a strategy that can be used to boost returns on a portfolio, but it carries some risk.
  5. Professionals

    How To Answer Option Questions On The Series 7 Exam

    Learn how to answer option questions on the Series 7 exam. Pass your Series 7 exam with the help of these tips.
  6. Options & Futures

    Write Covered Calls To Increase Your IRA Income

    Covered calls may require more attention than bonds or mutual funds, but the payoffs can be worth the trouble.
  7. Options & Futures

    What is a Bear Call Spread?

    A bear call spread is an option strategy that involves the sale of a call option, and the simultaneous purchase of a call option (on the same underlying asset) with the same expiration date but ...
  8. Options & Futures

    Fix Broken Trades With The Repair Strategy

    You can recover from your losses if you know how to use this handy trader's tool.
  9. Investing Basics

    What is a Bull Call Spread?

    A bull call spread is an option strategy that involves the purchase of a call option, and the simultaneous sale of another option (on the same underlying asset) with the same expiration date ...
  10. Options & Futures

    Naked Call Writing: A Risky Options Strategy

    Learn about this aggressive trading strategy to generate income as part of a diversified portfolio.
RELATED TERMS
  1. Bear Call Spread

    A type of options strategy used when a decline in the price of ...
  2. Call Ratio Backspread

    A very bullish investment strategy that combines options to create ...
  3. Bull Call Spread

    An options strategy that involves purchasing call options at ...
  4. Breakeven Point - BEP

    1. In general, the point at which gains equal losses. 2. In options, ...
  5. Ratio Call Write

    An option strategy in which an investor owns shares in the underlying ...
  6. Covered Combination

    An option strategy that involves the simultaneous sale of an ...
RELATED FAQS
  1. How risky is a covered call?

    Learn what a covered call strategy is, how investors use it, and the risk of a covered call strategy and how it offers limited ... Read Answer >>
  2. What is the maximum I can lose if I make a covered call?

    Learn what a covered call strategy is, how the strategy is created, and how to calculate the limited maximum loss on a covered ... Read Answer >>
  3. What options strategies are best suited for investing in the utilities sector?

    Learn about option strategies investors can use to take a position in the utility sector, including covered calls and option ... Read Answer >>
  4. What option strategies can I use to earn additional income when investing in the ...

    Learn how a covered call or covered put option strategy can be used to earn additional income on positions in stocks in the ... Read Answer >>
  5. What is the difference between a covered call and a regular call?

    Learn what a call option is, what two strategies call options can be used for, and the difference between a covered call ... Read Answer >>
  6. Where can I buy covered call ETFs (exchange-traded funds)?

    Learn where to trade covered call option strategies, and how covered calls work including the type of risk associated with ... Read Answer >>
Hot Definitions
  1. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  2. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  3. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  4. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  5. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  6. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
Trading Center