A customer buys 100 shares of XYZ stock at $80 and sells 1 XYZ Oct 80 Call at $4. What is the maximum potential gain for this covered call position?
- A$4,000
- B$800
- C$400
- DUnlimited
Show answer & explanationAnswer & explanation
Correct answer: C. $400
A covered call is established by buying stock and selling a call option. The maximum gain occurs if the stock price rises above the strike price, and the call is exercised. In this scenario, the stock is bought at $80 and the call is sold at $4. The maximum gain is the premium received plus any appreciation of the stock up to the strike price. If the stock goes above $80, the call will be exercised, and the customer will sell their stock at $80. Therefore, the maximum profit is limited to the premium received. ($4 premium * 100 shares = $400). The stock appreciation is offset by the obligation to sell at the strike price.
Why the other options are wrong
- A. This is the premium times 1,000 shares, not 100 shares, or it incorrectly factors in the stock price.
- B. This would be the profit if the stock went to $84 and the call was not exercised, which is not how a covered call works.
- D. A covered call has a limited maximum gain, not unlimited, because the gain from the stock is capped at the strike price by the short call.
Covered Call Maximum Gain
The highest possible profit achievable from a covered call strategy.
- Occurs if the stock price finishes at or above the call option's strike price.
- Calculated as the premium received from selling the call.
- The gain from stock appreciation is capped at the strike price.
Memory trick: Premium's the prize, when the stock price flies!