This is a simple, income generating strategy.
When to use
We can use the covered call strategy when we already have bought stock and we believe that the stock price will not exceed a certain price level within a certain period of time. Suppose that we have bought 500 shares of C at $20 and we believe that it will not be above $25 in one month. In this case we can sell five call options with strike price $25, expiration 1 month from now and premium let’s say $0.60. If the stock at expiration is below the strike price (OTM), the call options can’t be exercised against us so we will gain the full premium we have received as writers of the five options, which is $300 ($0.60x100x5) and we will also keep the stock. If the written calls are ITM at expiration, i.e. the stock is at $28, then they will be exercised against us and we are obliged to sell our shares to the buyer for $25 instead of $28 that we could sell them in the market. The advantage in this last case is that we have already bought the stock at a lower price ($20) so we will have a profit of $5/share ($2500) plus the premium we received ($300) minus commissions. The disadvantage is that if the stock keeps on rising we will not be able to make profit because we have already sold them.
So we can generate income without risking big losses from the exercising of the calls against us.
Loss/Profit at expiration
Maximum loss: Unlimited to the downside due to the stock position (to be exact until it goes to zero) – the proceeds from the written calls + commissions.
Maximum profit: Strike price of written call – the price at which we bought the stock + the proceeds from the written calls – commissions.
Below we can see the profit/loss diagram for the covered call strategy. We assume that 100 shares have been bought at $20 and the written call has a $30 strike price and premium $1/share.
Covered call strategy example
Suppose that we are long 100 shares of ERF (chart below) and we have bought them at $13.40 (point 1), because we believe that the market and the stock price will be rising for the next month. The stock has also visited a trendline support which is a good criterion for a long entry. We also believe that in a two months period the price will not exceed $19 because a strong resistance will stop its way up. In that case we can write one call with strike price $19 and expiration after two months if the premium is satisfactory enough to worth the risk.
If the stock price at expiration is below $19 then we have pocketed the full premium and we also have profits if the current stock price is above the price we bought it.