What Are Options? Calls, Puts, and Covered Calls

What follows is a transcript of the video above.

Let’s Try a Practice Question:

An investor owns 100 shares of ABC at 38 and sells 1 ABC February 40 Call at 3. What is the investors’ breakeven?

A. 35

B. 37

C. 41

D. 43

The correct answer is A.

Walking through this, notice that it is a special type of option strategy; it is considered more sophisticated or advanced and is called a covered call.

What Are Covered Calls?

A covered call is when we own the underlying shares and are also selling a call option in order to make a bit of extra money on the side. For hedge types of option strategy, the shortcut is going to be the cost minus the premium. In this case, that is going to be 38-3, so, the breakeven is 35. Use this shortcut here when Covered Calls pop up on the exam. Going step by step is helpful.

Positions:

First Position: Ask, “What is the position that an investor has for this question? I have 100 shares of ABC, and then ask, did we buy those shares, or did we sell those shares? We bought those shares at 38.

Second Position: Here is the call option that we wrote, ABC for a 40 Call. Ask, is it exercised or not? This is a breakeven question, therefore do not care if it is exercised or not. We do not even know what the stock is currently trading at. Therefore, it is not exercised, so, irrelevant.

Third Position: Look at the premium, and ask, “What is the premium that we paid, or what is the premium that we get? For the ABC February call, we made a $3 premium per share on that and did not buy any call options. We wrote one. I get $3 of premium. What is the profit/loss in this position? Well, it is going to be the sum of all the various positions that we currently have. That is going to be the 100 shares bought at 38 plus the call option. It was not exercised. Nothing happens there. We must neither buy those options nor sell them to anybody, therefore, that is a zero, and we get a premium of three.

How Does Profit & Loss Work?

The PL for this position is currently at 3. We spent 38 bucks per share to buy ABC, we wrote a call option and collected $3 of premium per share. Now our P&L is -35. Spend $38 per share to establish the position. Try going to get $3 of premium, so, sitting at a -35. In terms of how this relates to breakeven, if our profit/loss is -35, for us to breakeven, what would we sell the shares at? We can say, we neither gain nor lose money on this position. The answer to that is going to be 35. The same as that shortcut, but we just literally proved it by going step by step.

Trading Covered Call Options

If we go into the market and the shares are trading at 35, and we sell them at 35, we break even. We are indifferent. Well, let’s say, we know, the stock is trading at 41. The first position, 100 shares of ABC, did we buy or sell? We bought them for 38, nothing happened there.

Second position, the ABC February 40 Call, is it going to be exercised or not? If the stock is currently trading at 41, also assume that we are close to maturity here. We sold somebody a call option, think about the other side of the equation. If we sell a call option, that means somebody on the other side has bought a call option. Which that somebody has bought a call option with the right to buy at 40. If they have the right to buy at 40, and the market is trading at 41. All else being equal, we will exercise the call option. Because the market’s trading at 41, they can now buy it at 40. We are going to assume that this is going to get exercised. We must deliver these February shares to the person who bought the call option, because we have an obligation.

When you write a call option, you have an obligation to sell, whereas if you buy a call option, you have the right to buy something. So, as the seller of this call option, we are obliged to sell our shares of ABC to the buyer at the specified buying price. Therefore, this person will go, and exercise this call option, and they are going to buy these call options or these shares for 40 dollars a POP. Premium, we have already collected that premium.

At the bottom here, the premium is going to be unchanged. Therefore, our profit and loss in this scenario, if the stock is trading at 41, and our call option gets exercised, is going to be what? It is going to be +5, and now we are up five. Was this stock price relevant in our calculation of our P&L here? No, it was not. Our stock price here was irrelevant.

Call Options

If you think about Call Options another way, it is like the buyer is buying the stock from you at 40, they have a right to buy at 40, and you were obligated to sell it to them at 40, even though you bought this stock at 38, you wrote that call option. You are now going to turn around and sell it to the other person for $40, and you are pocketing the premium, allowing a person to buy a call option from you.

Profit and Loss on a Covered Call

Profit and loss on a covered call is always going to be capped. It is always going to be the difference between the strike here and the strike minus what we bought it for, plus, the premium that we collected. If we did not have the call option, but we just had shares and the stock price started to shoot up, then our gain is unlimited. In this case, because we wrote that call option, we are capping off our profit and loss. Therefore, if you are writing covered call options, you just want to collect premium and hope the call option does not get exercised so you do not have to go and sell it to somebody who wants to buy that call option.

Options are not as testable on the exam. You may see four to five questions on options, and this is as tricky as they will get. If you can walk through these various positions, first position, second position, premium, what is my profit and loss, what is the question asking of me, then you will be good to go for the exam. You will be more than prepared.