Assume that an investor purchased 100 shares of Hewlett‐Packard last year for $40 per share and this year, with the stock price at $48, writes a (covered) six‐month call with an exercise price of $50. The writer receives a premium of $4. This situation is illustrated in Figure 19‐7.

If called on to deliver the shares, the investor receives $50 per share, plus the $4 premium, for a gross profit of $14 per share (since the stock was purchased at $40 per share). However, the investor gives up the additional potential gain if the stock price rises above $50—shown by the flat line to the right of $50 for the covered call position in Figure 19‐7. If the price rises to $60, for example, the investor grosses $14 per share but could have grossed $20 per share if no call had been written.

Writing a naked call is also illustrated (by the broken line) in Figure 19‐7. If the call is not exercised, the writer profits by the amount of the premium, $4. The naked writer’s breakeven point is $54. This position will be profitable if the price of the stock does not rise above the breakeven point. The potential gain for the naked writer is limited to $4, whereas the potential loss is large. If the stock price rises sharply, the writer could easily lose an amount in excess of what was received in premium income.

Figure 19‐7

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Gain $ 30 20 14 10 0 -10 -20 T 10 Write a naked call Write a covered call 20 30 40 Market price 50 Purchase the stock 60 70