Question about selling covered calls.?

Question

Here is a scenario: Suppose friend A has $200,000 sitting in a bank account. Friend B sells covered calls and asks friend A to let him borrow the $200,000 for one week, and he'll repay the full amount plus a bit of interest. Friend A agrees and writes friend B a check for $200,000.

Friend B find an ultra-volatile stock (like Fannie Mae) and sells a Jan 2010 call using full $400,000 (50%) margin capabilities allowed by his broker. Friend B nets $220,000 in option premium.

My question is, can you write a check to friend A for his full amount plus a bit of interest once the premium hits the account?

What happens in a worst case scenario for Friend B who wrote the call?

Answer 1

In your example you are getting over 50% of the stock price back in the option premium. To do that, the option will have a strike price less than the stock price. You should be aware for margin purposes you have to use the lessor of the stock price and the strike price when valuing the stock.

<<<My question is, can you write a check to friend A for his full amount plus a bit of interest once the premium hits the account?>>>

Assuming the strike price was not too far in the money, federal minimum margin requirements would allow you to. However, every brokerage is allowed to use more stringent margin requirements than the federal minimum so you would have to check with your brokerage to determine if it would be allowed.

<<<What happens in a worst case scenario for Friend B who wrote the call?>>>

The stock gaps down and the implied volatility of the option skyrockets, forcing you to close all your positions and still have a huge debt to your broker who, by the way, will take legal action to collect that debt.