Series 4

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



comments powered by Disqus
Trading Center