Basic Options Strategies: Covered Call - Part Two
...Continued from Part One
Risk vs. Reward
Maximum Profit = Limited
Maximum Loss = Substantial
Upside Profit at Expiration if Assigned = Premium Received + Difference (if any) Between Strike Price and Stock Purchase Price
Upside Profit at Expiration if Not Assigned = Any Gains in Stock Value + Premium Received
Maximumprofit will occur if the price of the underlying stock you own is at orabove the call option's strike price, either at its expiration or whenyou might be assigned an exercise notice for the call before itexpires.
The risk of real financial loss with this strategycomes from the shares of stock held by the investor. This loss canbecome substantial if the stock price continues to decline in price asthe written call expires. At the call's expiration, loss can becalculated as the original purchase price of the stock less its currentmarket price, less the premium received from initial sale of the call.
Anyloss accrued from a decline in stock price is offset by the premium youreceived from the initial sale of the call option. As long as theunderlying shares of stock are not sold, this would be an unrealizedloss. Assignment on a written call is always possible. An investorholding shares with a low cost basis should consult his tax advisorabout the tax ramifications of writing calls on such shares.
BEP: Stock Purchase Price - Premium Received
If Volatility Increases = Negative Effect
If Volatility Decreases = Positive Effect
Any effect of volatility on the option's price is on the time value portion of the option's premium.
Passage of Time = Positive Effect
Withthe passage of time, the time value portion of the option's premiumgenerally decreases - a positive effect for an investor with a shortoption position.
Alternatives before expiration?
Ifthe investor's opinion on the underlying stock changes significantlybefore the written call expires, whether more bullish or more bearish,the investor can make a closing purchase transaction of the call in themarketplace. This would close out the written call contract, relievingthe investor of an obligation to sell his stock at the call's strikeprice.
Before taking this action, the investor should weighany realized profit or loss from the written call's purchase againstany unrealized profit or loss from holding shares of the underlyingstock. If the written call position is closed out in this manner, theinvestor can decide whether to make another option transaction toeither generate income from and/or protect his shares, to hold thestock unprotected with options, or to sell the shares.
Alternatives at expiration?
Asexpiration day for the call option nears, the investor considers threescenarios and then accordingly makes a decision. The written callcontract will either be in-the-money, at-the-money or out-of-the-money.
If the investor feels the call will expire in-the-money, he canchoose to be assigned an exercise notice on the written contract andsell an equivalent number of shares at the call's strike price.Alternatively, the investor can choose to close out the written callwith a closing purchase transaction, canceling his obligation to sellstock at the call's strike price, and retain ownership of theunderlying shares.
Before taking this action, the investorshould weigh any realized profit or loss from the written call'spurchase against any unrealized profit or loss from holding shares ofthe underlying stock. If the investor feels the written call willexpire out-of-the-money, no action is necessary. He can let the calloption expire with no value and retain the entire premium received fromits initial sale.
If the written call expires exactlyat-the-money, the investor should realize that assignment of anexercise notice on such a contract is possible, but should not beassumed. Consult with your brokerage firm or a financial advisor on theadvisability of what action to take in this case.
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