Saturday, October 3, 2009

Covered Call question

A customer just emailed me with the following concern:

I saw a question like the one below on the software my firm gave me--I think it's an internal product somebody higher up put together. I don't think there's a right answer. Can you help?

Here is the qestion:

An investor purchases 300 shares ABC @50 and writes 3 ABC Aug 55 calls @1.50. His maximum loss is . . .

I chose "unlimited" because of the short call position--what am I missing?


If the investor only wrote the three ABC Aug 55 calls, his risk would be unlimited, but this investor already bought the 300 shares he is obligated to sell and deliver for $55 a share. Therefore, he no longer worries about the stock rising; in fact, that would be his maximum gain. If the stock rises, he can make $5 per share plus the premium . . . maximum. His maximum loss is now pointing downward--he owns the stock. If it drops from $50 to zero, all he got to offset that was $1.50 per share. His maximum loss, then, is still $48.50 per share, times 300 shares.
That's why they say that covered calls provide "partial protection." The premium income is a nice way to "increase yield" or "increase overall return" on the stock, but it does very little to protect against a big drop. The best way to protect a long stock position, remember, is to buy a put. Having the right to sell your stock at a set price in case it drops is much better than having to sell your stock at a set price only if it goes up. I'm going to leave you with that thought--enjoy.

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