The covered call payoff, in three zones

A covered call payoff chart is a diagonal line that goes flat at the strike. Below your break-even you are losing on the shares. Between break-even and the strike you make the premium plus whatever the stock gained. Above the strike your profit stops moving, permanently, no matter how far the stock runs.

The shape is the argument. Once you have seen it you cannot unsee what this strategy trades away.

Build it from the two pieces

A covered call is two positions. Long 100 shares, which is a 45-degree line running up and to the right forever. Short one call, which is flat until the strike and then turns down at 45 degrees. Add them and the upward line goes horizontal at the strike. That is the whole diagram.

The premium shifts the entire line up by the amount you collected. It does not change the shape, only the height.

Zone 1: below your break-even

Take the KO example: shares at $71.40, $75 call sold for $0.62. Your break-even for this position, measured from today, is $70.78. Below that you are losing money, and you lose it at the same rate you would have if you had never written the call, just starting from 62 cents lower.

This zone extends all the way to zero. The maximum loss on a covered call is the stock going to zero, offset by the premium: $70.78 x 100, or $7,078 per contract in this case. People describe covered calls as conservative and then never mention that number. It is a real number and it has happened to real companies.

Zone 2: between break-even and the strike

The good zone, and the narrow one. Here you make the premium plus the share appreciation. At $74 on expiry day you have made $2.60 on the shares from $71.40, plus the $0.62 premium: $322 on the contract. Your best possible outcome sits at the far right edge of this zone, at exactly $75.

That maximum is $3.60 of share gain plus $0.62 of premium, or $422 per contract, and it is reached at $75.00 and at every price above it.

Zone 3: above the strike, where the line goes flat

At $80 you make $422. At $95 you make $422. At $140 you make $422. The line does not bend back down, which is the thing people misread: you do not lose money when the stock rockets. You just stop making any.

The loss is an opportunity loss and it does not show up on any statement. At $95 you made $422 while a buy-and-hold holder made $2,360 on the same shares. Nothing in your account will ever tell you about the $1,938. This is why the strategy feels better than it performs, and why the ten-year comparison is worth reading before you commit to it.

What the diagram hides

Two things, and both matter.

It is drawn at expiry. Before expiry the line is a curve, not a kink, because the option still has time value. A stock at $76 with three weeks left does not pay you the full $422, because buying the call back costs more than its intrinsic value. The diagram is where you end up, not where you are.

Early assignment is not on it. American-style equity options can be exercised any day, and around an ex-dividend date that stops being theoretical. The chart has no axis for that.

Draw your own position at the payoff diagram builder, which handles both legs and marks the break-even.

Questions people actually ask

Keep reading

• One full covered call, end to end
• Static return versus if-called return

Do the math on your own trade

• Payoff diagram builder draw the position and see the three zones.
• Covered call calculator premium, break-even, static and if-called return, annualized.
• Break-even calculator the price where the trade stops making money.

Every price in this article is an illustrative worked example, not a quote. Read Covered calls for the rest of the series, and the disclaimer before you act on any of it. Selling options carries real risk of loss, and the loss can be far larger than the premium you collected.