2

I hope that it's appropriate to ask this kind of question here and I'm not sure how to formulate it. I have a specific (real) example that I'd like to outline to see if I understand this correctly. Please confirm or correct my analysis.

Ignoring fees, suppose I bought 500 shares of stock A at $15.75 and after it dropped a dollar, I became concerned that its price might drop a significant amount more (a few dollars) but was reluctant to lock in the loss right now.

The May 2021 $10 strike call has a $7.30 premium. Does this mean I could write 5 call options and if the option is exercised I would make about $625? And if instead, the stock dropped below $10, I wouldn't lose anything as long as I sold the 500 shares before the price dropped below about $8.75?

I suspect that I've made an error because it seems too easy to get an 8% ish return for basically zero risk.

*** Thanks for the help. Accepted the answer I did because this bit

"The potential return of an option position reflects exactly what the market thinks it's worth. There's a reason for that."

reminded me not to fall into the trap of thinking that I know something the market doesn't (thinking of P/E ratios looking "cheap" or "expensive" etc).

Thanks!

Improve this question
2
  • I guess selling the shares if the price drops below 10 is risky in case it suddenly gaps up massively before expiry. – Aaron Shaw Feb 9 at 23:07
  • 1
    Selling the shares and keeping the short call open is a terrible idea for two reasons. The first is the risk of having the equivalent of a short position in the stock with theoretically unlimited upside loss potential. The other one is that IMHO, it's a bad idea to realize losses (sell the stock) while keeping a unrealized profit open. The market has a perverse way of making you pay for that. I prefer the opposite of booking the gain and defending the loss on the hope that the underlying will reverse in price. Converting to a spreads can be useful in such situations. – Bob Baerker Feb 10 at 0:19
0

You own a stock at $15.75.
If you sell a call for $7.30, You own the stock at a cost of $8.45, but are obligated to sell at $10, a gain of $1.55/share or $775 profit even if it drops another $4.75.

Zero risk? I've sold a $20 call on a $20 stock for $10. Thinking I'm up 100% if the stock stays flat. Somehow it went bankrupt.

The potential return of an option position reflects exactly what the market thinks it's worth. There's a reason for that.

Improve this answer
9
  • JTP - your calculations are off because you used the market price of $14.75 rather than the cost basis of $15.75 – Bob Baerker Feb 10 at 0:01
  • "As if you are a new purchaser of this covered call." and "(Yes, in your case, your profit is just $775.)" weren't enough. I understand. I should have answered OP and not the 'new buyer'. I'll edit. (The bar here is if you object, the mere mortal would be totally confused.) – JTP - Apologise to Monica♦ Feb 10 at 0:04
  • Edited out to answer OP's situation and not new buyer. – JTP - Apologise to Monica♦ Feb 10 at 0:05
  • Mere mortals post on Stack? I thought that only happened on Reddit. Answering the OP's question tends to be more useful here ;->) – Bob Baerker Feb 10 at 0:21
  • "Somehow it went bankrupt." - Yes, thanks. I was thinking "risk free" because if it tanks I could sell between strike price and $8.45 and still make a return or break even. But, of course, then I'd have infinite risk - especially if it's still some time until expiry. – Aaron Shaw Feb 10 at 0:46
1

When you sell a covered call, the buyer gives you a premium for the right to purchase 100 shares of your stock at the strike price until the expiration date. The entire premium is yours to keep if you are assigned (the buyer exercises his call and you must sell) or the call expires worthless in May.

If you purchase stock XYZ for $15.75 and sell a May 2021 $10 call for $7.30, your cost basis will be lowered to $8.45. If assigned, you will receive $10 per 100 shares. Since you own 500 shares, your gain will be $775 ($155 x 5).

A $1.55 return on a cost basis of $8.45 is a return of 18.3% in 66 days which annualizes to 101%.

... and if instead the stock drops below $10 I won't lose anything so long as I sell the 500 shares before the price drops below about $8.75 ?

No. You will not lose anything unless the stock drops below $8.45. If the stock drops before May expiration and you wish to close your short call, you will have to buy it back (a cost) and that will increase your cost basis and break even point.

If XYZ drops and it's much closer to expiration, an alternative to closing could be rolling your short call down and out (to a lower strike for a further expiration) for a credit, lowering your cost basis even more.

Improve this answer
0

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.