Call options are contracts to sell 100 shares of a stock at a particular price per share, known as the strike price, during a particular period of time. The call option seller, known as the “writer,” must deliver the stock if the option buyer chooses to exercise the contract. A type of call option known as the "covered" call is considered relatively low-risk but can rebound against the writer if a stock's price rises sharply.
How Cover Works
To understand where the risk lies, you need to understand the basics of covered call options. A covered call exists when the option writer already owns the stock that’s subject to the call. Covered call writers typically use these options to generate extra income from a stock holding. The option writer continues to own the stock and gets the dividends and voting rights. The covered call option writer essentially is betting that the price of the underlying stock won’t change much during the duration of the option contract.
Here's The Risk
The risk with covered calls is that the writer is limiting his upside profit potential if the stock’s price climbs substantially above the option strike price. For example, if Acme Corp. stock currently trades at $15 per share, an Acme shareowner might write a covered call option to sell 100 shares of Acme Corp. stock for $20 per share. He bought that stock years ago at $10 per share. He finds a buyer who will take the $20 option for $1 per share and the seller collects $100. If Acme’s stock price stays under $20 per share, the option won’t ever be exercised and the seller will pocket the $100.
If Acme stock were to rise above the $20 call option strike price, though, the covered option writer would lose out on some of that share price gain. If Acme stock reached $25 per share and the option buyer called for delivery of the 100 shares at the $20 strike price, the option seller must deliver the stock. He will have a capital gain of $10 per share over his $10 purchase price, plus the $100 he got for the option, for a profit of $1,100. But if he hadn’t written the call option, he could have sold his 100-share holding at $25 and gotten all the $15 gain above his $10 purchase price, for a profit of $1,500. By writing the covered call, the seller has forgone $400 in profits.
If the share price drops, though, the money received from selling a covered call option can offset some of the capital loss. If the price of Acme Corp. stock plunged to $8 per share, the investor would have a $2 per share capital loss relative to his $10 purchase price, for a total loss of $200 or 20 percent. At an $8 per share market price, there’s no chance the $20 call option will ever be exercised. The option writer can apply the $100 he got for the option against his $200 capital loss, cutting his 20 percent loss to only 10 percent.
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