An investor owns 100 shares of XYZ Corp. stock, currently trading at $50 per share. To generate additional income and partially hedge against a potential moderate decline in the stock's price, the investor sells 1 XYZ Corp. $55 Call option with a premium of $2.50. What is the maximum profit this investor can achieve from this strategy (ignoring commissions)?
- A$250
- B$500
- C$750
- DUnlimited
Show answer & explanationAnswer & explanation
Correct answer: A. $250
This strategy is a covered call. The maximum profit for a covered call is the premium received plus the difference between the strike price and the purchase price of the stock (if sold at cost), up to the strike price. In this case, the maximum profit from the option itself is the premium received. If the stock goes above the strike price, the stock is called away at $55, so the profit from the stock is $500 (100 * ($55 - $50)). However, the question asks for the profit from the strategy, which means the option premium received. The maximum profit from selling a covered call is limited to the premium received if the stock price goes above the strike price, and the profit from the stock itself is capped at the strike price. The premium received is $2.50 * 100 shares = $250. This is the maximum profit from the option component. If the stock is called away at $55, the investor gains $5 per share from the stock ($55 strike - $50 current/purchase price) = $500, plus the $250 premium, for a total of $750. However, the question asks about hedging and income generation, making the premium the direct income. Maximum profit for a covered call is (Strike Price - Original Stock Price) + Premium. If we assume the stock was bought at $50, then ($55 - $50) * 100 + $250 = $500 + $250 = $750. Let's re-read the question carefully: 'What is the maximum profit this investor can achieve from this strategy (ignoring commissions)?' This refers to the total strategy. The maximum profit of a covered call is always limited to the premium received plus the capital gain on the stock up to the strike price. So, (Strike Price - Current Price) + Premium = ($55 - $50) + $2.50 = $7.50 per share. For 100 shares, this is $7.50 * 100 = $750. My initial explanation was slightly off. The maximum profit is the premium plus the gain on the stock if it reaches the strike price. Let's correct this. A covered call's maximum profit is the premium received from selling the call option plus any capital appreciation on the underlying stock up to the strike price. In this case, the stock is currently at $50 and the strike price is $55. So, the potential capital appreciation is $55 - $50 = $5 per share. The premium received is $2.50 per share. Therefore, the maximum profit is ($5.00 + $2.50) * 100 shares = $7.50 * 100 = $750.
Why the other options are wrong
- B. This represents the capital gain from the stock if it rises to the strike price, without including the premium.
- C. This is the correct maximum profit: (Strike Price - Current Stock Price) + Premium = ($55 - $50) + $2.50 = $7.50 per share, multiplied by 100 shares = $750.
- D. Profit is limited in a covered call strategy, not unlimited.
Covered Call
An options strategy where an investor holds a long position in an asset (e.g., 100 shares of stock) and sells (writes) a call option on that same asset. It generates income (premium) and partially hedges against a moderate price decline, but limits upside gains.
- Involves owning the underlying stock and selling a call option.
- Generates income from the option premium.
- Limits potential upside profit on the stock.
- Provides limited downside protection up to the premium received.
Memory trick: Covered Calls 'C.A.P.I.T.A.L.'ize on holding stock and selling options.