Covered Calls SIMPLIFIED (SIE, Series 7, 65, 66) - YouTube

hi i'm brandon from basic wisdom before we  get started just a quick plug for achievable  

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the links below in the description let's take  a look at an income strategy question together  

pick it apart see if we can look at the inner  workings of what's going on so we can understand  

overall how to approach these strategies and  how to consistently get test questions on them  

correct all right in january an investor buys 100  shares of pdq stock when the market price is 60.  

after a few months the stock price goes to  70. the investor believes the market will  

not rise above 75 by the end of october to take  advantage they go short one pdq october 75 call  

collecting a 400 total premium okay there's a  lot given in this question it's kind of a story  

that they've presented us with here if you happen  to get one of these longer questions on the exam  

just hang in there take your time breathe  it's gonna be okay in reality there's there's  

only a couple things that happen here that are  important although there's a lot more language  

that's added that might make it seem like  there's a ton more going on essentially we  

have an investor that bought shares of pdq stock  at 60 and then later after the market price rises  

they sell or go short a october 75 call this  is an income strategy specifically a covered  

call remember a short call has unlimited risk  potential as a standalone single leg strategy if  

that 75 call is all by itself and the market price  rises significantly let's say up to a thousand  

the investor has an obligation to sell stock at  75 they'd have to go to the market buy stock at a  

thousand sell the stock at 75 through the option  being exercised and lose a ton of money if that  

were to occur but the call is covered by virtue  of the investor owning the shares of stock already  

they don't have to go to the market to buy shares  to to be able to deliver them at 75 or sell  

them at 75. now as the name suggests this is an  income strategy an investor is looking to create  

additional income specifically by selling the call  the call is not the primary focus for the investor  

the stock is the stock is really their money  maker but an investor would entertain the idea  

of an income strategy if they were to think  the market price were to stay flat over the  

next short term period in this case here until  the end of october investor buy stock at 60  

market price rises of 70 probably feeling pretty  good about themselves but hey maybe in the next  

few months they just don't think the stock  prices are going to go above 75. so by selling  

a 75 call they've essentially put a ceiling above  themselves at 75 remember call up put down call up  

if the market price rises above 75 that call is  going to be exercised forcing the investor to  

sell their stock at 75 remember what a short call  is the obligation to sell now going to the second  

question what is the market sentiment which just  means what is the investor hoping happens here  

and this is a tough question to answer with any  multi-part option strategy now why well for long  

stock which is bullish right whether the market  price to rise or shorter call which is bearish  

want the market price to fall the best way to  think about an income strategy is to prioritize  

and focus on the stock position the stock is  really what the investor cares most about and  

of course an investor that's long stock wants the  market to rise they're bullish but the problem is  

we've got a call that tells us hey if the market  price goes above 75 we're gonna get exercised and  

we're just gonna have to sell our stock at 75. so  if we put the big picture together this is really  

a bull neutral strategy i'd probably say mostly  neutral the investor here is selling the call for  

two reasons number one they're making a premium  off of the option and that's money in their pocket  

number two they don't think the market  price is going to rise significantly  

if they thought there was a chance that the  market price would rise significantly to 100 150  

or there's just a lot of upside potential in the  short term selling the call would be a bad move  

because again yeah the the call is going to  give you some money from selling the option  

it's going to give you that premium but if  the market price were to rise say the 150  

the investor would have made a lot more money if  they hadn't sold the call and that's why we'll  

call this a bull neutral strategy once  we go through some of the numbers below  

i think the big picture will start coming together  let's take a look at our handy dandy t-chart  

which is not an absolute necessity to answer  these questions correctly but a lot of people  

like t-charts especially visual based learners uh  and i i like t-charts myself because they help me  

keep the numbers straight and therefore i don't  have a bunch of numbers swirling around my head  

that i might forget or not keep track of this  is how my t-chart always looks i have a plus  

and minus column on the left and right side plus  would be from money in minus a medium from money  

out and then i have an option in a stock row let's  go ahead and fill out our t-chart for what we  

have just based upon what's in the question now  the investor buys 100 shares of pdq stock at 60  

and with that information i'm going to plug  a 60 on the minus column in the stock row  

i personally like using the small numbers meaning  60 dollars per share instead of putting thousand  

there could you put six thousand absolutely go  with whatever way looks best to you the only  

thing you have to remember though is if you use  small numbers like me you just gotta remember to  

multiply it times in this case 100 at the bottom  or multiply it by however many shares are involved  

if it was 300 shares and three calls that were  sold in this question we need to multiply times  

300 at the bottom just got to remember that one  part so again we have a 60 in the minus column  

in the stock row because we bought stock  at 60 that's money out of our pocket  

we will also plug in a four on the plus column  in the option row and that's because we sold  

that option for a total 400 premium on a per share  basis that would be four now some of you might  

be asking hey what about the 75 the 75 is the  strike price which may or may not come into play  

if the option is exercised of  course we'll plug 75 into the  

t chart if it goes unexercised then it won't go in  there the only thing that we can say affirmatively  

is that we sold an option and collected a  four dollar per share premium and that's  

how our t-chart will look and start with  every single math question that we come across  

a 60 on the minus column of four on the plus  column great now let's go to maximum gain the  

best way to think through any of the potentials  maximum potential gain maximum potential loss  

even break even the best way to think about this  is to use the stock as our starting point and the  

stock will really define where we want the market  to go where we don't want the market to go so if  

we think about it okay i'm long stock long stock  is a bullish strategy which means we'll make money  

if the market price were to rise can the market  rise infinitely is there any ceiling to the market  

no marking can go up up up up so if we  think about that sometimes it's easy to  

pick a number just go with an absurd number say  market price rises to a thousand that would be  

great for the stock position but we have to  make sure that we're keeping in mind what  

would happen to the option in that scenario at  a thousand the call is deep in the money call up  

remember calls get exercised if the market price  rises up above the strike price and at a thousand  

or technically any price above 75 that call is  in the money it has intrinsic value which just  

means in in a nutshell it's going to get exercised  most of the time when you're short an option you  

don't want that option to be exercised and in  this case if the market price were to rise to  

a thousand we would really hope that we didn't  get exercise but the reality is exercise is  

going to happen that call will be exercised by  the person that bought it forcing the investor  

to sell stock at 75 and we'll plug that in we'll  put a 75 on the plus column in the stock row  

and from that point we just need to add up all  the numbers that's the end of the story we have  

a 4 and a 75 on the plus side together that's 79  we have a 60 on the minus side we net those out  

together that leaves us with 19 on the plus side  multiplied times 100 it's a 1 900 maximum gain  

and that's why this is a bold neutral strategy  if the market price were to rise and the call  

gets exercised hey the investor is still making  money they're in fact they're going to make their  

maximum potential gain whether the market price  goes to 75 or a thousand or anywhere above 75  

they're at their maximum potential gain now if  the market price were to stay relatively flat or  

let's say the market price were to go up to 75 and  just stop investor would make money on the stock  

position plus the premium together hopefully that  helps paint the picture as the why this is a bull  

neutral strategy let's go ahead and reset the t  chart we still have a 60 on the minus side and a  

4 on the plus side now maximum loss we will think  about through the same lens as we did with maximum  

gain remember the stock is the primary focus of  this strategy hey if i'm long stock where's my  

maximum loss would be when the market price falls  and we don't have to think you know we don't just  

have to pick a number out of thin air here zero  is worst case scenario for our stock position  

if the market price were to fall all the way down  to zero we would lose all the value of our stock  

which wouldn't be good now the only other thing  we have to ask ourselves is what happens to the  

option in that scenario okay market price falls  all the way down to zero you think call up put  

down call up did the market price go up above the  strike price no at zero really any price below 75  

the option is out the money has no intrinsic value  which just means it's not going to be exercised  

it will expire worthless now there's a small good  from that and a big bad from that the small good  

is we keep the premium that's easy money right  don't have to do anything now the big bad part  

of it is the stock just lost a bunch of money and  the option is not helping us here there's one last  

step to our chart it would really just be kind of  putting in a useless number if we were to sell the  

stock at zero i would put a zero on the plus side  if we just want to complete the t chart and that  

would be the end of the story sell the stock for  nothing so we end up with a 4 on the plus side a  

60 on the minus side that leaves us with 56 left  over on the minus side times 100 that is a 5 600  

maximum loss of course this is not a hedging  strategy the the option's not there to protect the  

investor but i do want to point something out some  people call this type of strategy a partial hedge  

now why would we call it a partial hedge well  let's think about it if we bought stock at 60  

and the market price would have go all the  way down to zero that's a six thousand dollar  

loss there but by selling the call that put  400 extra dollars in the investor's pocket  

which reduced their risk level overall so could  it be argued the call acts as a partial hedge yeah  

and sometimes investors will even look at  this as a way to justify that a cover call  

is actually a really safe strategy if i were  to compare the stock position to the stock  

position with a short call the short call added  into the mix reduces overall risk for the investor  

which is why if we have an investor that already  owns stock recommending they sell a call against  

that stock is really not introducing much risk  at all in fact it's the opposite it's reducing  

overall risk and from a suitability standpoint  you might even see a test question where you  

recommend a covered call to a more safe or  conservative investor so the stock position  

is really where the investor is absorbing risk  or facing risk the short call is not introducing  

risk in fact again last time i'll say it it's  reducing risk overall for the investor and putting  

money in their pocket all that in exchange for  putting a ceiling above themselves f75 let's go  

ahead and wipe the t-chart clean we still have  a four on the plus side a 60 on the minus side  

and we get to break even break even is always  my biggest selling point to using a t-chart  

now this will work for any hedging or income  strategy that you come across if you can get to  

the point where you feel comfortable enough  with just filling out the t-chart for what  

happened in the question in this case here we  have a 4 on the plus side a 60 on the minus side  

there's only one question we have to  ask ourselves to answer break even  

and that is what number could we introduce that  would give us a balanced out t chart in particular  

where would the stock price need to go  to give us the same number on both sides  

there's only one answer to that if  56 is plugged into the stock row  

on the plus side we end up with 60 on both  sides and that is our breakeven t-charts are  

great for break-even questions because there's  only one number we could plug in that would give  

us a balanced out t-chart now let's think  about this a little bit more conceptually  

the investors sold an option for a total of a  400 premium and if they were to buy stock at  

60 and then just sell this call hey if the market  price were just to stay flat at 60 they're still  

going to collect that 400 total premium they're  still going to be profiting at that point  

so maybe one way to think about this is if i sell  an option against the stock position i will break  

even only if the market price falls by the amount  of the premium i collected if i lose four dollars  

per share in the stock position that will offset  the four dollars per share i made by selling the  

option so for those of you who like formulas by  the way i'm not a big fan of formulas for options  

just because there's a million of them but with a  covered call the price the stock is purchased at  

minus the option premium on a per share basis  will tell you break even every time let's go  

ahead and wipe the t-chart clean we still have  four on the plus side 60 on the minus side  

now for the last few questions this is us thinking  through okay let's say the market price goes here  

what would be our gain or loss so let's think  about what happens market price goes to 77.  

okay think about the stock first we can  always take this on a step-by-step basis  

at 77 that's good for the stock bought  stock at 60 goes up to 77. that's a 17  

per share gain we're pretty thrilled with  that but we can't forget about the option  

at 77 there's only one question to ask ourselves  is the option getting exercised remember call up  

okay market price goes up above the strike price  of 75 the option will be exercised are we there  

yes the call will be exercised so in this case  here at 77 really doesn't matter it could be  

77 it could be 88 it could be 5 000 doesn't  matter that call is going to get exercised  

forcing the investor to sell their stock at 75 so  we put a plus 75 on the stock row and that's the  

end of the story feels pretty similar to maximum  gain right we end up with a 79 on the plus side  

a 60 on the minus side end up with a 19 left  over on the plus side times 100 gets us to a 1  

900 gain last question gainer loss at 40. well  approach it pretty similarly to the last question  

think about the stock first okay he bought stock  at 60 market price falls down to 40. oof not i'm  

not terribly thrilled with that that's a 20 per  share loss next thing we got to figure out is  

what happens to the option will it be exercised  call up did the market price go up above 75  

no the calls out the money has no intrinsic value  and at 40 we can assume it'll expire so if this is  

the end of the story here investor is just going  to be selling their stock for 40 so we'll plug a  

40 on the plus side in the stock row let's add up  our numbers we have a 44 on the plus side a 60 and  

the minus side that leaves us with 16 left over  on the minus side times 100 that's a 1 600 loss

you