The Options Industry Councils Covered Call example

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  1. The Options Industry Council's Covered Call Example: A Beginner's Guide

The Options Industry Council (OIC), an industry resource for options education, frequently uses the **covered call** strategy as a prime example to illustrate the fundamentals of options trading. This article will delve deeply into the OIC's typical covered call example, breaking down each step, explaining the rationale behind it, and outlining potential outcomes. We will build a comprehensive understanding of this foundational strategy suitable for beginners. This explanation will cover everything from stock selection to profit/loss scenarios, risk management, and variations.

    1. What is a Covered Call?

Before diving into the example, let's define the covered call. A covered call involves *owning* 100 shares of a stock (the "covered" part) and *selling* (or "writing") a call option on those same shares. The call option gives the buyer the right, but not the obligation, to purchase your 100 shares at a specific price (the **strike price**) on or before a specific date (the **expiration date**).

The reason it’s called “covered” is because you already own the underlying asset (the stock). If the option buyer *exercises* their right to buy your shares, you are obligated to sell them at the strike price. If the option buyer does *not* exercise the option, you keep the premium you received for selling it.

The primary goal of a covered call is to generate income from a stock you already own and are willing to potentially sell at a specific price. It's generally considered a conservative options strategy, as it offers limited downside protection but also caps potential upside profit.

    1. The OIC's Common Example: ABC Stock

The OIC often uses a hypothetical stock named ABC, trading at $50 per share, as the basis for their covered call examples. Let's follow their typical scenario:

  • **Stock Owned:** 100 shares of ABC stock, purchased at $45 per share. Your initial investment was $4,500 (100 shares * $45/share).
  • **Current Stock Price:** $50 per share. Your stock is currently worth $5,000 (100 shares * $50/share), representing a $500 unrealized profit.
  • **Call Option Sold:** You sell one call option contract on ABC stock with a strike price of $55 and an expiration date one month from now.
  • **Premium Received:** You receive a premium of $1.00 per share, or $100 for the entire contract (1 contract = 100 shares).

Let's break down what’s happening and why. You believe ABC stock might not rise significantly in the next month. You are okay with selling your shares at $55 if the price rises above that level. By selling the call option, you are essentially saying, "I'm willing to sell my shares at $55, and I want to be compensated for that willingness." That compensation is the $100 premium.

    1. Scenario 1: ABC Stock Price Remains Below $55 at Expiration

This is the most favorable outcome for the covered call writer.

  • **Stock Price at Expiration:** $52 per share.
  • **Option Outcome:** The call option expires worthless. The buyer will not exercise their right to buy your shares at $55 when the market price is only $52.
  • **Your Profit:**
   * **Stock Profit:** $200 ($52 - $45) * 100 shares = $200 (unrealized, as you still own the stock).
   * **Premium Received:** $100.
   * **Total Profit:** $300.
  • **Analysis:** You benefited from the premium received *and* a slight increase in the stock price. Your overall return is higher than if you had simply held the stock without writing the call option. Your breakeven point is now $44 ($45 purchase price - $1 premium received).
    1. Scenario 2: ABC Stock Price Rises Above $55 at Expiration

This is where the covered call's upside potential is capped.

  • **Stock Price at Expiration:** $58 per share.
  • **Option Outcome:** The call option is exercised. The buyer will exercise their right to purchase your shares at $55, as that's below the current market price of $58.
  • **Your Profit:**
   * **Stock Profit:** $500 ($55 - $45) * 100 shares = $500 (you sell at $55).
   * **Premium Received:** $100.
   * **Total Profit:** $600.
  • **Analysis:** While the stock price rose to $58, you only profited as if it had risen to $55. You "gave up" the potential $3 per share gain above the strike price in exchange for the $100 premium. This is the trade-off of a covered call. You capped your upside, but you still earned a profit.
    1. Scenario 3: ABC Stock Price Falls Below $45 at Expiration

This illustrates the downside protection offered by the covered call, although it's limited.

  • **Stock Price at Expiration:** $40 per share.
  • **Option Outcome:** The call option expires worthless.
  • **Your Loss:**
   * **Stock Loss:** $500 ($40 - $45) * 100 shares = $500.
   * **Premium Received:** $100.
   * **Net Loss:** $400.
  • **Analysis:** You lost money on the stock, but the premium you received partially offset that loss. The covered call provided a small cushion against the downside. Without the call option, your loss would have been $500. The premium acted as a buffer.
    1. Key Considerations and Risk Management
  • **Strike Price Selection:** Choosing the right strike price is crucial.
   * **At-the-Money (ATM):** Strike price close to the current stock price (e.g., $50 in our example).  Offers a higher premium but a greater chance of being exercised.
   * **Out-of-the-Money (OTM):** Strike price higher than the current stock price (e.g., $55 in our example). Offers a lower premium but a lower chance of being exercised.  This is the OIC's typical example.
   * **In-the-Money (ITM):** Strike price lower than the current stock price. Offers the highest premium but is almost guaranteed to be exercised.
  • **Expiration Date Selection:** Shorter expiration dates generally offer lower premiums but quicker income. Longer expiration dates offer higher premiums but tie up your shares for a longer period.
  • **Early Assignment:** While rare, call options can be exercised before the expiration date. This usually happens if there's a dividend payout or if the stock price moves significantly in the money.
  • **Tax Implications:** Selling covered calls has tax implications. Consult a tax advisor for specific guidance.
  • **Diversification:** Don't rely solely on covered calls for income. Diversify your portfolio to manage risk.
  • **Volatility:** Higher implied volatility generally leads to higher option premiums. Consider the volatility of the underlying stock when choosing a covered call strategy.
    1. Variations of the Covered Call
  • **Rolling a Covered Call:** If your stock price is approaching the strike price, you can "roll" the call option. This involves buying back the existing call option and selling a new call option with a higher strike price and/or later expiration date.
  • **Covered Call Ladder:** Selling call options at multiple strike prices to create a range of potential profits.
  • **Diagonal Spread with Covered Call:** Combining a covered call with a long call option at a different strike price and expiration date.
    1. Expanding Your Knowledge: Further Resources and Concepts

To truly master options trading, consider exploring these related concepts and resources:

The OIC's covered call example provides a solid foundation for understanding this popular options strategy. Remember to thoroughly research and understand the risks involved before implementing any options trading strategy. Practice with Paper Trading before using real capital.



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