Page 82 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 7: Option Strategies and Pay-offs

Notes
Figure 7.2: Profit/Loss at Expiration for Short Put

3. Covered Call: This is the result of long underlying asset and short call options. This
strategy is used by many investors who hold stock. It is also used by many large funds as
a method of generating consistent income from the sold options.
The idea behind a Covered Call (also called Covered Write) is to hold stock over a long
period of time and every month or so sell out-of-the-money call options. Even though the
payoff diagram (Figure 7.3) shows an unlimited loss potential, we must remember that
many investors implementing this type of strategy have bought the stock long ago and
hence the call option's strike price may be a long way from the purchase price of the stock.

Example: Say we bought SBI last year at 925 and today it is trading at 940. We might
decide write a 945 call option. Even if the market sells off temporarily it will have a long way
to go before we start seeing losses on the underlying. Meanwhile, the call option expires worthless
and we pocket the premium received from the spread.

Maximum Loss: Unlimited on the downside.
Maximum Gain: Limited to the premium received from the sold call option.
When to use: When we own the underlying stock (or futures contract) and wish to lock in
profits.
Figure 7.3: Profit/Loss at Expiration for Covered Call

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