A question about covered calls when I get exercised.

Discussion in 'Options' started by fencerd4, Mar 21, 2009.

  1. fencerd4


    I have a friend who have been debating with me about how I will actually lose money in the following scenario.

    1000 Underlying stock price purchased at $1 a share. Then I write 10 $2.5 covered call for 3 month later and collect 10c each.

    Max profit if exercised above $2.5 eg. $3 = $2500+$100.

    From what how I understand it, if the exerciser exercises the contract above the strike price, he forgoes all of the contracts value. Right? So, the above is my gain.

    However, my friend thinks that if I am exercised above the money, then I will have this scenario:

    Max profit if exercised above $2.5 eg. $3 = $2500+$250- the increase in value of the option I wrote (eg. option now worth 50c). According to him, I lose money because my profit is now $2500+100-400.

    Can you guys please tell me who correct here. I was told by two expert option traders my friend is wrong, but I would like to verify with you guys. Thank you.
  2. fencerd4


    Correction: Max profit if exercised above $2.5 eg. $3 = $2500+$100- the increase in value of the option I wrote (eg. option now worth 50c). According to him, I lose money because my profit is now $2500+100-400.
  3. johnnyc


    your friend is wrong. you keep what you sold the calls for initially and you sell your stock @ 2.50 that's all that happens with a covered call.
  4. When you are assigned an exercise notice on a call option, you sell stock at the strike price.

    Thus, your statement: "if exercised above $2.5 eg. $3..." doesn't mean anything.

    If assigned (that's the proper terminology), you collect $2.50 per share. It does not matter if the stock is $3, $4, or $6,000. You get the strike price per share.

    So, if you paid $1 per share and sold @ $2.50 per share, your profit is $1,500 (not $2,500). You also keep the option premium, so add $100 to that profit. Don't forget to subtract commissions.

    Your other question: When the call owner exercises, the option is canceled. That means the option is worthless and the call exercises owns stock at the strike price - no matter how much higher it may be trading.

    You didn't ask, but - it's almost always a bad idea for the individual investor who owns options to exercise them (there is no need to discuss the exceptions here). It's easier to sell the option.

  5. fencerd4


    Thanks guys
  6. Maximum profit if exercised is $1,600, computed as follows:

    a. Net Debit to open position: 90 cents ($1.00 price of stock less 10 cent call premium received).

    b. Selling Price if exercised: $2.50, or $2,500.

    c. Profit: $2.50 less .90 = $1.60 x 1,000 shares = $1,600.

    I recently did something like this with AGI. But the written call was an April. By the way, in your example, the maximum risk is $.90 per share, or $900. Thus, in computing your return on investment, your denominator is $900.

    I love this type of trade. I could write covered calls on stocks trading under $5.00 all day long. The idiots who invested with Bernie Madoff wanted just 10% per year return. Just think where they would be if they had written their own covered calls on low priced stock.

    By the way, do you guys know what a covered put write is?

  7. fencerd4


    It is the opposite of the covered call strategy.

    You first short the underlying at e.g $5 and you write a covered put for $2.5.

    Your max profit on the underlying is $2.5 (from $5 to $2.5). Covered puts are a bit risky than covered calls due to the fact that a stock can move up to infinity and can at most retrace to 0.
  8. spindr0


    The short answer is that it's equivalet to a naked call.

    If you're dealing with $2.50 to $5 stocks, the infinity thing may have some relevance since zero isn't far away. But in the real world (say the likes of AMZN, ISRG, GOOG, etc.), it's not relevant since the stock is never going to rise by the amount of its current price... at least not before anyone with a modicum of money management deals with it.

    AKAIK, riding a short wave down is a lot easier than the upside since markets don't melt up :)
  9. Sorry, I meant to say "AIG" above. What the hell, I'm an accountant who focuses too much on "AGI", which is Adjusted Gross Income.