Covered Call Strategy

CFA Level I
#1

Are large losses more likely to occur (on a covered call strategy)…

  1. If the underlying share price increases sharply before the investor can sell the shares and buy back the calls

OR

  1. If the underlying share price decreases sharply before the investor can sell the shares and buy back the calls

I feel like the correct answer is the first one, given the fact that if you do not sell those shares you can lose out on making you profit from your position in the underlying stock, while those who have a long call position will exercise (as the higher underlying price will make the stock in the money) and you will have to pay up. This should create a large loss to your covered call position.

However, the answer is the second one. and I am not sure why?

#2

I believe that they’re talking about actual losses, as opposed to foregone gains.

If you buy a stock at $25 and sell a call with a strike of $30:

  • If the stock price falls to $10, you lose $15 (less the call premium, but that’s sunk)
  • If the stock price rises to $40, you gain $5 (plus the call premium, but that’s sunk)
#3

Ok. How are you supposed to know if they are talking about actual losses rather than foregone opportunity costs in a question like this?

#4

If the share increase sharply BEFORE the investor can sell the shares, this does not constitute a problem, because you are still participating in the profit from the increase in the underlying and you can use that profit to pay back the calls (similar to the $40 outcome that S2000 described). If it falls sharply then you are dealing with the losses since you did not sell yet. Since all of the scenarios deal with BEFORE the actual liquidation of the position, this is the plain vanilla case of the covered call and you can pretty much apply the standard calculations (see S2000’s answer for that).

#5

Keep it simple.

Losses are losses. Buy high, sell low.

#6

To save time thinking too much, you can remember it quickly like this: A covered call P/L and payoff will look like a “SHORT PUT”. A short put incurs losses if the stock price falls. Simple!!! P/L = +Time Value of Call Premium - Stock Price at Purchase + Strike Price (if stock price is higher than strike) OR + Stock Price at Sale if the Stock falls below the Strike Price. If the stock price moves up - profits are limited: because you are making a profit due to the premium earned and the fact that the stock is sold at the strike price which is a positive. You wouldn’t have to pay up the “loss” because this is not cash settled. You sell the stock to the long option holder. If the stock price falls, you would be selling the stock lower than what you purchased it for and secondly, you would not like to buy the call back even if it is cheaper (because you’re already making a loss and wouldn’t want to add to your losses by making a purchase).