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NISM Certifications · NISM-Series-VIII: Equity Derivatives · Strategies using Equity Futures and Equity Options

An investor owns shares of a company and sells an out-of-the-money call option on them, receiving a premium (covered call). What is the main trade-off of this strategy?

In a covered call the investor earns the premium income but forgoes gains above the strike price, since the shares would be called away. Downside risk on the shares remains, only partly cushioned by the premium received.

  1. AUnlimited loss if the price rises sharply
  2. BPremium income gained but upside above the strike is given upCorrect
  3. CProfit if the price falls, with no loss
  4. DProtection against a fall in price below the strike

Explanation

The shares are held, so a rising price does not create unlimited loss; the call is covered. The investor earns the premium but any gain above the strike is surrendered. Downside on the shares is only cushioned by the premium.

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