CFA Practice Question

CFA Practice Question

The maximum profit under a covered call position is ______.
A. ∞
B. the premium received
C. the exercise price
Explanation: The maximum profit on a covered call position (short call and long stock) is the premium earned by the writer. When the stock price rises above the exercise price, the stock is called away, depriving the writer of the stock's gain, leaving the premium for him as his profit.

User Contributed Comments 10

User Comment
mirco Does this not depend on the price you paid for the long stock?
nike the purchase price is determined by the market and has nothing to do with the max profit here.
robz Covered call profit/loss diagram = Short put profit/loss diagram.
akjohn1 people who agree with this answer clearly don't see this strategy in their everyday work. The premium received is the max profit for THE CALL PORTION of a buywrite position. However, a buywrite has two components, and we MUST consider the max profit of the combined position, in which case, the max profit is premium + (strike price - stock price).

As a counterexample, consider the strategy of buying a stock and selling an deep ITM call. To think that the max profit is the entire premium for the call is a falacy, because in realizing the entire profit from the call, you lose significantly in the value of the stock.
Shalva For a covered call, the strike price is the same as the current stock price. So the investor would buy a stock at price X, write an option which has a strike price of X. Then no matter what happens the maximum profit would be the premium of the call option. This is a classical example of covered call. akjohn1 assumes the strike price would be different which is not the case here.
JCopeland This is not correct. The only way it could be is if we assume what shalva did, that the exercize price is the current stock price. This is rarely the case. More often than not covered calls are written out of the money (rather than at or in).
Therefore, the actual answer which would be correct in every scenario for maximum profit would be Call Premium + (Excercise Price- Inital Stock Purchase Price)

The Premium recieved is the maximum profit recieved on a call option, not on a combination of stock and option.
yessir yes you need to assume the strike price is the same as the purchase price. That is, an investor wants to use the strategy, he will buy the stock at price X and then write the call option at a strike price of X.
Saibot akjohn1 is absolutely right, no doubt about it. mutual funds work with covered call writting where strike price is higher than stock price
Kunga Agree with others above, this question is vague since the answer depends on what the strike price is.

Choices A and C don't make any sense for covered calls though, which led me to answer B.
ctschro i seem to prefer JCopeland's analysis here too
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