Understanding covered calls—an analogy

I know that analogies usually confuse more than they help—but that’s not going to stop me from trying…

Imagine that you are the season ticket holder of 4 good seats for a major league football team at the beginning of the season. A lot of people think the team is headed for the Superbowl, but you are pessimistic. You’d like to cash in on the current hype and get some money now for the last home game of the season. On craigslist, you offer to sell the rights to this game. Your offer doesn’t force the buyer to buy the tickets but gives the buyer the right to buy the tickets from you at face value any time before the game.

If your team is undefeated 4 games into the season the value of your offer will go up. If the last game of the season determines whether the team goes to the playoffs or not your offer could become quite valuable—essentially the difference between what the scalpers are charging for comparable tickets and the face price of the tickets.

On the other hand, if your team is near elimination from the playoffs halfway through the season your offer will be almost worthless—who would pay money for the right to buy tickets at face value that will probably be cheap on the street? If the last game of the season ends up being a meaningless contest between two loser teams you will probably have to sell your tickets at a discount if you don’t want to go yourself.

Your offer on Craig’s list has similar characteristics to selling stock options on stock you own—a covered call. You give up the upside on an asset you own in exchange for money upfront. No laws of nature have been broken—relax…

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