covered call

CFA Level II
#1

For a covered call, if I purchased the stock at 50 and sold a call option at 55 plus premium of 4. So isn’t my breakeven gonna be 50 because that is the price at which I bought the stock.

Also why is the breakeven and max loss calculated the same way?

Could you please explain in simple terms the value at expiration

#2

Your break even is actually 46. You got a premium of 4 dollars… If you sold the stock at 50, you made $4 on the transaction stil… therefore, the breakeven is 46 which is where you would make $0.

The Max loss is if the stock went to nothing… Your max loss would be $46 because you would have lost $50 on the stock but you still made $4 on the call option.

#3

At time 0, you made $4 from selling the call. If the stock goes to $60, you gain $10 from the stock, and lose $5 from the call, giving a net gain of $5. You made $4 from selling the call, the net gain is $5 + $4 = $9. If the stock stays $50, you gain $0 from the stock. You made $4 from selling the call, so net gain is $4.

If the stock goes to $46, you lose $4 from the stock, the call expires. You made $4 from selling the call, so your net gain is $0. So, $46 is the breakeven price. To calculate maximum loss, consider if the stock goes to $0. You lose $50 on the stock, but you had made $4 from selling the call. So your maximum loss is $46. Hope that’s helpful. This is how I remember break-even prices and max/min losses for any option plays.

#4

Wait, sorry I hadn’t read Tactics comment/explanation. I will let you know if I understood after reading it.

#5

Wow thanks Tactic that was immensely helpful. Could you please also explain time value at expiration?

#6

At expiration:

  • If the stock price is 55 or less, then the call option is worthless, so the value of the covered call is simply the stock price
  • If the stock price is above 55, then the value of the call option is stock price − 55, and the value of the covered call is stock price − (stock price − 55) = 55
#7

I didn’t get the second point you were trying to make.

#8
  • If the stock price is 56, the value of the call is 1 (= 56 − 55)
  • If the stock price is 60, the value of the call is 5 (= 60 − 55)
  • If the stock price is 987, the value of the call is 932 (= 987 − 55)

The value of the covered call is the value of the stock less the value of the call:

  • If the stock price is 56, the value of the covered call is 55 (= 56 − 1)
  • If the stock price is 60, the value of the covered call is 55 (= 60 − 5)
  • If the stock price is 987, the value of the covered call is 55 (= 987 − 932)