Thursday, December 24, 2009


Buying a Share and Selling a Call

A naked option is a position where the option writer does not hold a share in her portfolio that has a counterbalancing effect. The investor can protect herself by talking a covered position.

A covered call position is an investment in a share plus the sale of a call on that share. The position is covered because the investor holds a share against a possible obligation to deliver the share. The total value or pay off of a covered call at expiration is the share price minus the value of the call.

The value of call is deducted because the investor has taken a short position; that is he is under an obligation to deliver the share to the buyer of the call option if he chooses to exercise his option. The buyer of the call will do so when the exercise price is lower than the share price.

An Example,

Assume that a call option is at the money; that is both the current price of the share and the exercise price is 100$. Further, suppose the possible share price at expiration is either 110$ or 90$.

When the share price is equal to or less than the exercise price, the investor’s pay off will equal to the share price.

The investor’s maximum pay off to a covered call cannot exceed the exercise price in the rising market. He sacrifices the opportunity of earning capital gains in favorable of enhancing the current income by premium. Investors who are in any case planning to sell shares at a price equal to the exercising price will follow the strategy.

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