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At-the-money Covered Call Example

Notice that the time-value portion of the premium collected, using the midpoint price, is $155.  That’s about an 8.7% return. 

But before you get too excited, look at the Delta on the trade.  It indicates about a 57% probability of this trade exceeding the strike price.  On the other hand, there is a degree of downside protection afforded in this trade due to the option premium collected from selling the call so the break-even point on the trade is lower that the strike price.  In this example, your break-even point is: $17.82 less $1.87, or $15.95.  If you interpolate the Deltas, you can estimate that there is roughly a 75% chance of exceeding the break-even point.

So there you are, staring down the barrel of a fixed 8.7% return (in about 30 day’s time) and roughly a 75% possibility of success.  Would you do it?  The answer depends on your risk-return preference.  Now look at the in-the-money example.

In-the-money Covered Call Example

In covered call writing, the most you can expect to gain from writing a covered call is the “time value” portion of the option premium.  (Watch video on Time Value.)  Time values are always highest at-the-money, but is worthwhile to study time values at some of the other strike prices, as well, because as you go further in-the-money, the probability of realizing the time value increases.

In the example above, compare the two blue-shaded strikes and look at Delta (last column) as a rough probability-of-success indicator to get an idea of the risk return tradeoff between the two strike prices.  The $12.50 strike has $0.23 in time-value premium with a 96 Delta (probability) and the $15 strike has a $0.68 time-value premium with a 82 Delta.

Focus on the $15 strike for a moment.  Assuming the stock does not fall below $15.00 your expected profit from this covered call position will be $68.  In percentage terms, your return on investment would be 4.7%  and the strategy will break-even at $14.32.  Using Deltas as an ad hoc indicator, there is roughly a 90% change that the stock will exceed $14.32 at expiration.  Is that an acceptable risk-return from your point of view?

Out-of-the-money Covered Call Example

If you want to collect premium while avoiding the seemingly unpleasant scenario of having your shares called away, then consider writing an out-of-the-money covered call.  This strategy appeals to traders who feel it is “messy” to have shares called away.  In this example, the premium collected from writing the out-of-the-money call is $90 per contract.  That might seem like extra revenue for very little risk, but there are some disadvantages.

First, as with any covered call strategy, your upside profit potential is capped -- although there is still room for the stock to appreciate in value up to the higher strike price.  Second, if you ever want to unwind a position, for instance to realize a quick gain on the underlying stock, you have to “buy-to-close” your option position before you can sell the stock.  (You can’t be naked the short option.)  So it becomes a two-legged transaction.  First, you have to close the option position you sold, and then you have to sell the stock.  Sometimes the cost of buying back the option is more than the premium you collected for selling it in the first place -- which can get ugly.

And finally, you do not get as much downside protection with an out-of-the-money covered call.  If you write calls at higher strike prices, you are more exposed to a decrease in the value of the stock shares you hold.