Is Covered Call Writing A Zero Sum Game? Let’s Do The Math

 | May 14, 2017 12:54AM ET

Many assume that covered call writing is a zero sum game because we have traders executing equal but opposite trades using the same underlying security. As a covered call writer, we may sell 5 contracts of AAPL which means there is a buyer out there who just bought our contracts. If we win, they lose and vice-versa, right? Well, let’s examine, the Blue Collar way. We will set up two hypothetical scenarios, first for naked options and then for covered call writing and see if either can be viewed as a zero sum game.

Hypothetical trade scenario

  • BCI is trading at $50.00
  • The $50.00 at-the-money call is priced at $1.00
  • The stock price moves up to $53.00 (scenario I)
  • The stock price moves down to $47.00 (scenario II)

Naked option trading: Stock price moves up to $53.00 by expiration

The call buyer paid $1.00 for the option which is now worth $3.00 in intrinsic value resulting in a profit of $2.00. The call seller generated an initial profit of $1.00 and now is required to either buy back the option for $3.00 (plus a small time value premium) or buy the shares at $53.00 to deliver them at $50.00. Either way, there is a net loss of at least $2.00. This scenario does appear to be a zero sum game given no exit strategy execution and leaving both positions until contract expiration.

Naked option trading: Stock price moves down to $47.00 by expiration by expiration

The call buyer paid $1.00 for the option which expires worthless resulting in a loss of $1.00. The call seller generated $1.00 from the sale of the option which expires worthless resulting in a net profit of $1.00. Once again, given no position management maneuvers and allowing the trades to last until expiration, this does appear to be a zero sum game.

Covered call writing: Stock price moves up to $53.00 by expiration

Assuming no exit strategy executions, the call writer generates a profit of $1.00 on the sale of the option and shares are sold at $50.00, the price paid for the stock, netting a profit of $1.00. The call buyer paid $1.00 for the option which is now worth $3.00 in intrinsic value resulting in a net profit of $2.00. This does not appear to be a zero sum game.

Covered call writing: Stock price moves down to $47.00 by expiration

The covered call writer generates an initial profit of $1.00 on the sale of the option and has an unrealized share loss of $3.00, resulting in an unrealized loss of $2.00. The option buyer paid $1.00 for the option which expires worthless resulting in a loss of $1.00 again telling us that covered call writing is not a zero sum game.

Is it possible for one position to make money and the other to lose money?

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Yes, if share price moves down less than the option premium originally generated, the covered call writer will make a profit while the naked option buyer will be in a losing position. Let’s say share prices declines to $49.50. The covered call writer will have a net credit of $0.50 per share or $50.00 per contract. The option buyer will lose the $1.00 paid for the option which expires worthless.