How Can Covered Call Help You to Potentially Hedge Your Long Position? A Case Study of TUTU Company

A covered call is a bullish strategy that involves simultaneously buying 100 shares of the underlying stock or ETF and selling a call option. You might consider this strategy if you expect a stock you hold for the long term won't rise dramatically in the near future. The call you sell helps hedge your long position, and the premium earned might enhance your potential income.

Today we'll take a hypothetical stock TUTU as an example and look at how this strategy could be used in real trading.

Strategy Introdution

1. Construction of the strategy

Buy a Stock + Sell Call Options
You buy the stock and sell call options on a share-for-share basis.

2. Practical Scenarios

Let's break down this two-part strategy.
On the one hand, buy the shares. This trade suggests investors are bullish on the stock.
On the other hand, sell the call options. This trade alone suggests investors are not that confident the stock will go up.

Hence, the covered call strategy can be considered when one investor believes the stock will go up in the long term but doesn't think it will rise substantially in the near term.

(Note: This strategy is typically more appropriate for investors who want to hold the stock for the long term, instead of those who want to take advantage of the short-term fluctuation.)

Case Study

Let's go over a hypothetical case study to help illustrate how this strategy can work.

Suppose there is a theoretical stock TUTU listed on the NASDAQ exchange. Optimistic about its sound business model, Bob believes its stock price will go up in the long run. However, as the recent collapse of banks weakened market sentiment, Bob is convinced that TUTU's stock price will not rise significantly in the near future, so he decides to take the Covered Call strategy.

1. Open position

① Buy the underlying stock

Bob buys 100 shares of TUTU at US$50 per share.
It costs Bob US$50*100 = US$5,000.

② Sell the call

Simultaneously, he sells a call for US$5 with a US$55 strike price that expires on 04/22/2023. The multiplier is 100.
Total Premium Received Per Contract = US$5*100=US$500

Total Cost of Covered Call = Cost of Buying the Underlying Stock - Premium Received = US$5,000 -US$500 = US$4,500

2. Strategy Analysis

Here is the P/L diagram of the strategy.
We can see from the chart that theoretically the maximum profit is US$1,000, and the maximum loss is -US$4,500.

（Note: All profits and losses below are calculated based on the assumption that you choose to exercise the option at expiration, excluding commissions and other charges. In real trading, you can either exercise your option or close your position before expiration, and the actual profit and loss will vary.）

3. Scenarios

Let's discuss the four possible P/L scenarios under two different conditions.

4. Gain & Loss

Breakeven Point = Stock Purchase Price - Premium Received
Maximum Loss = (Stock Purchase Price - Premium Received) * Multiplier * Contract Size
Maximum Gain = (Call Strike Price - Stock Purchase Price + Premium Received) * Multiplier * Contract Size

5. Features of the Strategy

In a covered call, the primary position is the long stock position and the short call is the secondary position. Still, the overall gain and loss is largely determined by the stock's price changes.

(Note: The covered call strategy essentially sacrifices some upside potential of the underlying in exchange for less potential loss. Therefore, Covered Call is considered a relatively conservative strategy. Theoretically, the loss of this strategy is limited, and the maximum loss is achieved if the price of the underlying stock falls to $0. The potential profit of this strategy is also limited, and the maximum gain is achieved if the price of the underlying stock rises above the strike price.)

6. Factors to Consider

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