Assume a particular stock, ZYX, is currently trading at $41.85, and the investor thinks this might be a good purchase. Three-month $45 calls can be sold for $1.25. Historically, ZYX has paid a quarterly dividend of $0.25 cents. By selling the three-month $45 call, the investor is agreeing to sell ZYX at $45 should the owner of the call decide to exercise their right to buy the stock. The call owner may exercise the call if the market price of the stock is above $45, because the call holder will be able to buy the stock for less than it is currently trading for in the open market. But the investor’s return will be greater than if the stock had been held until it reached $45 and then was sold at that price.
Consider what happens to a covered call position as the underlying stock moves up or down. Commissions and taxes have not been taken into account in these examples.
Example; Buy 100 ZYX at $41.85 and sell 1 three-month $45 call at $1.25. There will be three possible scenarios at expiration.
Scenario 1: ZYX remains below $45 between the present and expiration – call not assigned
The call option will expire worthless. The premium of $1.25 and the stock position will be retained. In effect, the investor will have paid $40.60 (which is the breakeven price) for ZYX ($41.85 purchase cost minus the $1.25 premium).
When ZYX call expires worthless, the investor can sell another call going further out in time, thus taking in additional premium. If ZYX remains below $45 for an entire year, the investor can sell these calls four times. For the purpose of this example, we will make the assumption that the price of the stock and option premiums remain constant throughout the year. The investor’s income or this covered call would be calculated as follows:
$1.25 (call premium) x 4=$5 in premium+any dividends paid = Total Income
Scenario 2: ZYX rises above $45 between the present and expiration – call assigned
The call buyer can exercise their right to buy the stock and the investor will be obligated to sell ZYX at $45, even though ZYX has risen above $45. However, it should be noted that the investor has taken in the premium and may have been earning dividends on the stock.
If ZYX stock is called away at expiration:
Receive |
$45 for stock
$1.25 for premium
Total received |
$4,500.00
$ 125.00
$4,625.00 |
Less |
$41.84 stock cost |
($4,187.50) |
Net Income |
|
$437.50* |
*excludes dividends paid (if any) |
Scenario 3: ZYX is at $45 at expiration
The investor may face the outcome in either scenario 1 or 2. The stock may be called away and the investor will be obligated to sell ZYX at $45. Alternatively, the stock may not be called away. A call could then be sold again by the investor, going further out in time, bringing in additional premium and further reducing the investor’s breakeven point
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