Covered Call Example
An investor purchases 100 shares of iShares SLV, an Exchange Traded Fund (ETF) designed to mirror the price of silver. Those shares currently were purchased at $18.50 each, for a total investment of $1,850.
The investor decides to write a covered call contract on those shares, at a strike price of $20, set to expire in two months. The buyer of that covered call pays $.50 per share, or $50 total. (Contracts are written in 100-share increments; one contract is worth 100 shares.) The investor has immediately reduced his downside risk if SLV shares fall. His new cost basis is $18.00 per share ($18.50 – $.50 – $18.) One of the advantages of writing covered calls is that while losses cannot prevent losses, doing so can certainly reduce the overall impact of potential losses.
Think of it this way: If you own shares in an ETF worth $1,000, and you write covered calls for $.50, you are immediately up $50; if those shares decrease in value, the $50 can offset some or all of that decrease. And if the shares simply stay flat, you are now up $50 – for an immediate return of 5%.
If the share price drops the option buyer is unlikely to exercise the option at a higher strike price since the stock could simply be purchased for a lower price on the open market. In that case, the writer of the covered call keeps the premium paid for writing the covered call. He is then free to write more covered calls, further minimizing his risk and increasing his return.
If the share price rises to the strike price, the person writing the covered calls receives the strike price and keeps the covered call premium. His only upside risk is that the shares appreciate dramatically – in that case he misses the opportunity to profit from that appreciation, since his shares were called away at the strike price.
Here’s a more detailed covered call example.
Say an ETF currently trades at $99 and $105 calls are currently priced at $2 per share.
An investor purchases 100 shares of that ETF for a total investment of $9,900 and immediately writes one covered call, receiving a premium of $200; his new cost basis is immediately reduced to $9,700. As a result the $200 premium received for writing the covered call covers a $2 decline in share price. The breakeven point of the transaction is now $97 per share.
On the flip side, the investor’s total appreciation potential – during the term of the covered call – is limited to $6 per share, or $600. Remember, if the stock price rises to $105 or higher the purchaser of the covered call can exercise his option at $105. Total investor profit will be $6 per share ($105 – $99 = $6.) While the investor’s upside is limited, a $6 profit is slightly more than a 6% return; add the $2 per share option premium and his return is over 8%.
If the stock price at the expiration of the call is below $105, the call option will expire. The investor can then sell those shares if he wishes, or write another covered call to continue to generate returns and cash flow.
The only way the investor experiences a loss is if the price falls to below $97 and he sells his ETF shares.
