A Covered Call Concept
Everyone loves to get something for nothing. When covered calls end up expiring worthless that is exactly what happens. The writer (seller) received money for the call premium. An option that goes unused means the seller ‘won’ without giving up anything (keeps premium, keeps underlying stock).
Many people think that seeing short calls expire worthless is the ‘best case’ result. They're wrong. To understand why, do the math.
Assume we own 100 XYZ Corporation which trades at $45 per share. Pretend the bid on the October $50 calls is $2. Selling one covered call contract at that price brings in $2 x 100 shares = $200.
If XYZ finishes at $45, unchanged from its inception-date price, on expiration Friday:
We started with 100 XYZ shares worth $4,500. When the trade concluded we finished holding the original 100 XYZ shares, still worth $4,500, plus the $200 from the call premium = $4,700 in total value.
If the underlying shares declined in price by anything greater than the $2 per share premium we collected, our position would have less total value than when we bought the shares and sold the call.
The call money received was 100% profit. Did that really represent the maximum possible profit? No. The movement of the stock matters too.
Consider the result achieved if XYZ ends at $50 or higher on the option’s expiration date.
The call writer would be forced to deliver 100 XYZ shares when the option is exercised at the $50 strike price. The option owner would then pay him $50 x 100 shares = $5,000. The call seller would also have the $200 from the call premium received.
Final position = No shares + $5,200 of cash.
Total Value = $5,200.
What would you rather have on the option expiration date… $4,700 (including shares of stock) or $5,200 (no stock–but you can buy your 100 shares back for $4,500)?
Sure, it rankles when the underlying shock shoots above the strike price. Call sellers capped the upside and miss out on the full move.
So do not sell covered calls at strike prices lower than where you would be willing to part with your shares.
One of the ‘risks’ in covered call writing is the same as in selling any stock. There is always a chance that those shares go higher afterwards and you miss the ride. Another risk is that the premium collected is insufficient to cover a drop in the share price. The risk that the shares drop is not eliminated by the covered call strategy, but it is mitigated by the premium you collected.
The key concept is simple.
Once you have sold covered calls, having the options exercised represents the best case scenario.
