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Out-Of-The-Money Covered Call
This is a covered call strategy where the mildly bullish investor sells out-of-the-money calls against a holding of the underlying shares.
| Covered Call (OTM) Construction |
| Long 100 Underlying Sell 1 OTM Call |
Limited Profit Potential
Profit potential when writing out-of-the-money covered calls is higher than writing in-the-money calls since the call writer can participate partially in the price appreciation of the underlying stock.
The formula for calculating maximum profit is given below:
- Max Profit = Strike Price of Short Call - Purchase Price of Underlying + Premium Received - Commissions Paid
- Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
Unlimited Risk
Potential losses for this strategy can be very large. Furthermore, as lower premiums are received, downside protection is also reduced.
The formula for calculating loss is given below:
- Maximum Loss = Unlimited
- Loss Occurs When Price of Underlying < Purchase Price of Underlying - Premium Received
- Loss = Purchase Price of Underlying - Price of Underlying - Premium Received + Commissions Paid
Breakeven Point(s)
The underlier price at which break-even is achieved for the covered call (otm) can be calculated using the following formula.
- Breakeven Point = Purchase Price of Underlying - Premium Received
Example
An options trader purchases 100 shares of XYZ stock trading at $50 in June and writes a JUL 55 out-of-the-money call for $2. So he pays $5000 for the 100 shares of XYZ and receives $200 for writing the call option giving a total investment of $4800.
On expiration date, the stock had rallied to $57. Since the striking price of $55 for the call option is lower than the current trading price, the call is assigned and the writer sells the shares for a $500 profit. This brings his total profit to $700 after factoring in the $200 in premiums received for writing the call.
It is interesting to note that the buyer of the call option in this case has a net profit of zero even though the stock had gone up by 7 points.
However, what happens should the stock price had gone down 7 points to $43 instead? Let's take a look.
At $43, the call writer will incur a paper loss of $700 for holding the 100 shares of XYZ. However, his loss is offset by the $200 in premiums received so his total loss is $500. In comparison, the call buyer's loss is limited to the premiums paid which is $200.
Summary
Overall, writing out-of-the-money covered calls is an excellent strategy to use if you are mildly bullish toward the underlying stock as it allows you to earn a premium which also acts as a cushion should the stock price go down. So if you are planning to hold on to the shares anyway and have a target selling price in mind that is not too far off, you should write a covered call.