In this part, I will discuss how to set up a covered call by an example.
Let us assume that I bought 100 shares of CMI @ 66.07 per share with a total investment of $6607 on Friday April 09, 2010. I can sell a call option for $1.50 per share netting $150.00 per contract for the expiry in month of May with a strike price of $70.00. One contract of option consists of 100 shares. My net cost per share will be 64.57 that is break even point for this contract, totaling $6457.00 per contract.
What are the possible scenarios at the expiry date.
1. If the value of stock rises above $70.00, I will make 5.43 per share and option will be exercised thus creating a net return of 8.40% for little over month (Expiry date is May 21).
2. If value of stock remains between $64.57 and $70.00 then the option will expire worthless and I will be able to keep 1.30/share free, that is, a return of 2.3% minimum.
3. If value of stock falls below $66.07 then a call premium will help to reduce my losses up to $64.57/share. My loss will start if stock falls below $64.57.
Summing up, this strategy does not eliminate the risk of investment completely but it does help to reduce the risk when prices are falling and enhances the returns when prices are stagnant.
