Trading Strategy: The Covered Call
Carl holds 1,000 Woolworths (WOW) shares, currently trading at $26.50. He receives company dividends as income from holding these shares, but he is looking for an opportunity to generate additional income from his investment. Carl’s market outlook for WOW is for the share price to remain steady over the short term, so he decides to sell 1 July WOW $27.00 Call for a premium of $1.05.
Trade Date: 5 May
Sell 1 x July WOW $27.00 Call @ $1.05
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Notes
– If Carl’s outlook for WOW proves to be correct, that is, WOW remains at $26.50 until the sold Call Option expires in July, he will successfully generate additional income from his shares. In this case Carl will generate $1050.
Income = Premium received * Shares Per Contract
($1050 = $1.05 x 1000)
– Carl’s profit is limited beyond the exercise price of the sold Call. In other words, if the WOW price rises above $27 before the July expiry date, say to $29, Carl’s profit for selling the $27 Call is $1.55 – as opposed to a possible $2.50 profit if he were selling the underlying WOW securities. If the underlying WOW share price exceeds $27, Carl will be assigned – meaning he is obligated to sell 1,000 WOW share at $27 to the purchaser of the $27 Call Option. Therefore, for Carl:
Maximum Profit = Assignment Sale Price – Share Purchase Price + Premium
$1.55 = ($27.00 – $26.50 + $1.05)
– Selling covered Calls effectively reduces the break-even point of buying the shares. So if Carl bought 1,000 WOW at $26.50, and has now received an additional $1.05 for selling a covered Call Option, the break-even point is:
Net cost = Share Purchase Price – Premium
($25.45 = $26.50 – $1.05)
So the share price of WOW has to fall below $25.45 before Carl makes a loss.
– In this strategy, the maximum loss is the cost of entering the strategy. The maximum loss is derived from holding the underlying WOW shares. If the WOW share price falls to zero, Carl will lose everything he paid to enter this strategy:
Net cost = Share Purchase Price – Premium
($25.45 = $26.50 – $1.05)
Carl can sell his holding of 1,000 WOW shares and buy back the July $27 Call Option at any time to limit his maximum loss.
Other articles in this week’s newsletter
How those in the know make money – and lots of it
Expert Panel: What are covered calls and how can you profit from them?
Top 10 CFD stocks for the week
Stocks & Stats to watch out for this week
Important Information
The views expressed in this article are those of Matt Comyn, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814. Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814 is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 and a Participant of the ASX Group and the Sydney Futures Exchange. As this information has been prepared without considering your objectives, financial situation or needs, you should, before acting on this information, consider its appropriateness to your circumstances and if necessary, seek appropriate professional advice.
