Covered Call Investing - An Example

A portfolio owns 1,000 shares of XYZ Company stock trading at $25 per share.  A $27.50 call option expiring in 6 months is sold (written) on XYZ stock for $2 per share, thus the portfolio receives $2,000 of income, representing an 8% return to the portfolio for the 6 month period.  There are a few possibilities of what may happen next:

- The stock price remains unchanged at the end of 6 months: the portfolio's return is 8% (because the $2,000 income is retained)

- The stock price declines 10%:  the portfolio's net return is -2% because the 8% income return offsets the decline in stock price

- The stock price climbs to $27.50: the portfolio's net return is 10% for the stock price plus 8% for the income for a total return of 18%

- The stock price climbs higher to $30:  the portfolio's return is limited to 18%.  In exchange for the potential for downside protection, the upside potential is limited.

Madison believes call options on individual stocks provide the opportunity for larger premiums than call options on indexes with similar expiration dates.

 

The writer of a covered call option forgoes, during the option's life, the opportunity to profit from increases in the market value of the security covering the call option above the sum of the premium and the strike price of the call, but retains the risk of loss should the price of the underlying security decline.