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Covered Calls
by Igor 02-28-2012, 03:49 PM

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A covered call strategy is an approach for traders who own an underlying asset. The method allows them to make a profit when the underlying asset's market price goes up moderately and to buffer losses if market prices go down. The strategy limits profits to only what is gained on paper plus any premiums earned. Loss potential is the same for any investor holding the underlying asset, but traders who leverage their assets by using a covered call strategy can cushion shortfalls in their portfolio.

Definition of OTM and ITM for Covered Calls
There are two ways to define the relationship between an option's strike price and the market price of its underlying asset. Understanding the differences between the terms is important because the risks involved in implementing a covered call strategy depend on these terms at the time of writing the option.

OTM - Out of The Money: The underlying asset's market price is less than option's strike price.
Example:
- Call Option XYZJan55 (strike price $55)
- XYZ is trading at $50

ITM - In The Money: The underlying asset's market price is more than option's strike price.
Example:
- Call Option XYZJan45 (strike price $40)
- XYZ is trading at $50



How to Implement a Covered Call Strategy (OTM)
XYZ is trading at $50 (market price)
1) Trader buys 100 XYZ shares for $5000 (100 x $50 share cost)).
2) Trader writes (sells) the option: XYZJan55($2)
- 100 shares of XYZ stock
- Strike Price $55 (OTM), expiring in 30 days
- Premium Cost of $2
3) Trader receives $200 from the buyer (100 x $2 (premium cost)).
Total Investment cost: $4800 ($5000-$200)

Result one: XYZ hits $57 (ITM). The call buyer exercises the option to buy 100 shares at $55. The call seller sells his or her 100 shares and receives at $5500, for a total profit of $700 ($5500 received from buyer - $4800 total investment cost).

Result two: XYZ hits $43 (OTM). The call buyer lets the contract expire. In this example, the option seller would keep the asset and the $200 in premiums, but would suffer a $700 loss on paper ($4300 asset's worth -$5000 paid). The total loss reduces to $500 when adding the premium.

Advantage and Disadvantage of a Covered Call Strategy:

Pluses: The upside to this type of strategy is that traders get to earn a premium on top of any paper gain their from owned assets. Another advantage to the covered call strategy is that premiums can reduce any loss incurred from a decline in the underlying asset's market price.

Minuses: The downside to implementing a covered call strategy is that a trader's profits are limited to only the gain on paper plus the premiums received from the call buyer. The investor can not receive any future profits from gains the underlying asset's market price because he or she would have sold the asset upon assignment.

Examples of Implementing a Covered Call Strategy ITM:
In the example above the investor sold the call OTM. Traders can choose to write an option at ITM, which will give them more leverage against declining market prices.

Example:
XYZ is trading at $50 (market price)
1) Trader buys 100 XYZ shares for $5000 (100 x $50 share cost)).
2) Trader writes (sells) the option: XYZJan45($8)
- 100 shares of XYZ stock
- Strike Price $45 (ITM), expiring in 30 days
- Premium Cost of $8
3) Trader receives $800 from the buyer (100 x $8 (premium cost)).
Total Investment cost: $4200 ($5000-$800)

Result: The trader's profits are reduced if the option expires ITM, but his or her losses also reduce if the underlying asset's market price falls, providing an $800 cushion instead of $200, compared to the example above.
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Old 02-29-2012, 05:04 AM   #2

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Re: Covered Calls

covered calls is work but not in every situation. whenever I apply it works only situation when market is getting trend according to covered call concepts

I don't thinks so it really works!
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