Question

You own a stock that costed you $159. You decide to sell call options in the money and gain a premium of $2. The strike price is $158. What is the profit equations? Determine the breakeven point, the maximum profit and loss. What is the name of this strategy? In which market do you use this strategy? Is it more a hedging strategy or speculation?

Answer 1

The name of the strategy is covered call.

You have written an In-The-Money call option, so you use this strategy when you think the stock is going to trade sideways or slightly bearish.

$2 premium contains $1 of intrinsic value and $1 of time value. $1 of time value is your maximum profit.

Profit equation = (St - S0) - max(St - X, 0) + Premium received

St is the price of the stock at expiry.

S0 = 159

X = 158

Premium received = 2

Breakeven = S0 - premium received = 159 - 2 = $157

Max profit occurs when the stock trades at or above the strike price

Max profit = (158 - 159) - max(158 - 158, 0) + 2 = $1

Max loss occurs when the stock goes down to 0 at expiry

Max loss = (0 - 159) - max(0 - 158, 0) + 2 = -$157

The Covered Call strategy is more of a hedging strategy than speculation because you make money in the call option when the stock price goes down a little bit.

Hope you understand this. Can you please upvote? Thank you :-)