Wednesday, February 11, 2009

Covered Call Maximum Loss

I saw a question somewhere (don't have it with me) where the investor owns 100 shares and has written a call. The maximum loss doesn't make sense to me--help!

Actually, this is a little tricky at first. Most students focus so hard on the call the investor wrote that they forget it's the stock we should be worrying about. Let's say that Laura buys 100 shares of XYZ @75 and writes an XYZ Oct 80 call @2. This is a "covered call" because she has the 100 shares she is obligated to deliver should the stock rise above $80. If you look at that outcome, you notice it represents Laura's maximum gain. She owns the stock and, therefore, wants it to rise. But, if it rises above $80 per share, she has to sell it at $80 a share, period. So, her maximum gain is $500 on the stock plus the $200 premium, or $7 per share.
On the other hand, if the question asks about Laura's maximum loss, you have to turn things around. Remember--she bought 100 shares of XYZ for $75 a share. All she took in was $2 a share for writing the covered call. She would have been at risk to lose $75 a share; now she can lose $73 per share. Not much downside protection, right? That's why the exam may say that a covered call writer "receives partial protection and increases her overall return." That's just a fancy way of saying, "she gets a premium." The premium she receives is her "downside protection," and it is her increased overall return.
So, you have to be analytical--like a chess player--when working a question like this. Ask yourself what happens if the stock rises; what happens if it drops. If it rises, Laura gains $7 a share. If it drops to zero, she could lose $73 a share--that's just the price she paid for the stock minus the premium she collected.

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