Covered call example
Let’s suppose a trader owns 100 shares in company ABC, which they think have a strong chance of generating profit in the long term. But in the short term they expect the share price to fall – or to not increase dramatically – from the current price of CHF 50.
As a result, the trader decides to sell a call option on the same stock with a strike price of CHF 60. They will earn a premium by selling this call option, but they will cap the total upside potential of their share investment at CHF 60 – or a CHF 10 profit per share.
In this example, let’s assume that the premium for this call option is 100p per share. Since options are always traded in lots of 100 shares, the trader stands to receive a total premium of CHF 100.
The trader will generate a profit for all gains up to a share price of CHF 60, after which any additional profits will be offset by losses incurred on the short call option. This is because it is now above the stated strike, meaning the option is 'in-the-money'.
As a result, the maximum the trader stands to gain is the CHF 100 premium, plus CHF 10 profit per share. So, their total profit is capped at CHF 1100 (for an underlying share price of CHF 60 or greater) because they own 100 shares.
Now, if the share price rises to levels greater than CHF 60, the trader will not realise these additional gains – or to be more accurate, gains in the long ABC position have been offset by losses on the short call.
However, for lesser upward movements – or drops in share price – the premium obtained by selling the call serves as a useful source of revenue, either to increase profits or to mitigate losses.