Options QA

An Example of a Covered Call Writing

Are you interested in generating income from your stocks? One strategy that you might consider is covered call writing. This strategy involves selling call options against a stock that you own in order to collect the premium income. It can be a useful way to generate extra income, especially in a flat or declining market. In this article, we’ll explore what covered call writing is and provide an example to illustrate how it works.

What is Covered Call Writing?

Covered call writing is a strategy in which an investor sells call options on a stock they already own. The call options give the holder the right, but not the obligation, to buy the underlying stock at a specific price (the strike price) before the option’s expiration date. By selling a call option, the investor receives a premium payment from the buyer, which they get to keep regardless of whether the option is exercised.

If the stock price stays below the strike price, the call option will expire worthless, and the investor keeps the premium. If the stock price rises above the strike price, the buyer of the option may exercise their right to buy the stock at the lower strike price. In this case, the investor must sell the stock to the buyer at the agreed-upon price, but they still get to keep the premium they received from selling the call option.

Example of Covered Call Writing

To better understand how covered call writing works, let’s look at an example using two characters, Naomi and Glen.

Naomi owns 100 shares of XYZ stock, which is currently trading at $50 per share. She believes the stock will remain relatively stable in the short term, but she also wants to generate some extra income from her position. To do this, she decides to sell a covered call option.

Glen is a trader who thinks that XYZ stock is going to go up in price over the next month. He buys a call option from Naomi, with a strike price of $55 and an expiration date of one month from now. He pays Naomi a premium of $2 per share for the option, which means Naomi receives a total of $200 ($2 x 100 shares) in income from the transaction.

If the stock price remains below $55 per share at the expiration date, Glen’s call option will expire worthless, and Naomi keeps the $200 premium income. If the stock price goes above $55 per share, Glen can exercise his right to buy the shares from Naomi at the lower strike price. For example, if the stock price goes up to $60 per share, Glen can buy Naomi’s shares for $55 each, giving him a $500 profit on the trade ($60 – $55 x 100 shares), while Naomi still keeps the $200 premium income she received for selling the call option.

Conclusion

Covered call writing can be an effective way to generate income from a stock position, especially in a flat or declining market. By selling call options on a stock they already own, investors can collect premium income while potentially limiting their downside risk if the stock price rises. However, it is important to understand the potential risks and rewards of this strategy before using it. As with any investment strategy, it is always a good idea to consult with a financial professional before making any decisions.


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