Covered Call

When people buy a call option, they would make profits if the market price of stocks is higher than the strike price of the call option. If the market price of stocks is lower than the strike price of call option, they would lose the amount of cost when they purchase a call option. When they sell a call option, they also have possibilities to lose or gain. However, if they purchase covered call, their profit could be a double and lose could be reduced an half. This is how covered call works. When people buy stock of A which we call an underlying asset, they also buy a call option of stock A at the same time. Then, they sell the call option. When the market price is lower than the strike price which they are already sold, they could make profits from the premiums by selling the call option. For example, let’s assume the stock price is $50, the exercise price is $55, and the premium of call is $4. The covered call buyers can make $9 profit ($55-$50+$4). If the market price is higher than the exercised price, the covered call buyer’s payoff would be reduced. Nevertheless, some people think when the market price is higher the covered call buyers can make profits from their premiums by selling a call option, and their stock price of A also goes up. I think that also make sense. However, the important thing is how much the market price goes up. If the difference between the market price and exercised price is less than the call option premiums, the covered call buyers still can make a profit. For example, let’s assume the stock price is $57, the exercise price is $55, and the premium of call is $4. Even though the covered call buyers should sell the stock with exercised price, $55, to the call option buyers, the covered call buyers still could make a profit $2 ($57-$55+$4). Nevertheless, if the difference between the market price and exercised price is higher than the call option premiums, the covered call buyers would loss. For example, if the market price goes $70, they would loss $11($70-$55+$4).
In conclusion, the potential profits of covered calls are limited, but the potential losses of covered calls are in unlimited. I think most of financial derivatives also make limited profits and unlimited losses


http://www.investopedia.com/articles/optioninvestor/04/021104.asp

http://www.forbes.com/2009/04/06/options-income-portfolio-personal-finance-investing-ideas-covered-calls.html

http://en.wikipedia.org/wiki/Covered_call