A covered call involves a seller offering buyers a call option at a set price and expiration date on a security that the seller owns. Professional market players write covered callsto boost investment income.Individual investors can also benefit from the conservative but effective covered call option strategy by taking the time to learn how it works and when to use it.
Read on for more about a covered call and the ways that it can enhance income, lower portfolio risk, and improve investment returns.
Key Takeaways
- A covered call is a popular options strategy used to generate income for investors who think stock prices are unlikely to rise much further in the near term.
- A covered call is constructed by holding a long position in a stock and then selling (writing) call options on that same asset, representing the same size as the underlying long position.
- A covered call will limit the investor's potential upside profit and may not offer much protection if the stock price drops.
What Is a Covered Call?
You are entitled to several rights as a stock or futures contract owner, including theright to sell the securityat any time for the market price. Covered call writing sellsthis right to someone else in exchange for cash, meaningthe buyer of the option gets the right to purchaseyour securityon or before the expiration dateat a predetermined pricecalled the strike price.
A call option is a contract that gives the buyer the legal right (but not the obligation) to buy shares of the underlying stockor one futures contractat the strike price at any time on or beforeexpiration. If the seller of the call option also owns the underlying security, the option is considered "covered" because they can deliver the instrumentwithout purchasingit on the open market at possibly unfavorable pricing.
If the contract is not a covered call, it is called a naked call, used to generate a premium without owning the underlying asset.
Covered Call Visualization
In the diagram below, the horizontal line is the security's price, and the vertical line is the profit or loss potential. The dots on the profit or loss potential line indicate the amount of profit or loss the covered call seller might experience as the price moves.
On the horizontal price line, the seller would break even when the price intersects a profit or loss potential of zero. The contract seller will likely set the strike price at the point they think the price will intersect the profit potential limit, indicated by the blue dot on the price line.
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Profiting from Covered Calls
The buyer pays the seller of the call option a premiumto obtain the right to buy shares or contracts at a predetermined future price (the strike price).The premium is a cash fee paid on the day the option is sold and isthe seller's money to keep, regardless of whether the option is exercised.
A covered call is therefore most profitable if the stock moves up to the strike price, generating profit from the long stock position. Covered calls can expire worthless (unless the buyer expects the price to continue rising and exercises), allowing the call writer to collect the entire premium from its sale.
If the covered call buyer exercises their right, the call seller will sell the shares at the strike price and keep the premium, profiting from the difference in the price they paid for the share and the selling price plus the premium. However, by selling the share at the strike price, the seller gives up the opportunity to profit from further share price increases.
When to Sell a Covered Call
When you sell a covered call, you get paidin exchange for giving up a portion offuture upside. For example, assume you buy XYZstock for $50 per share, believing itwill rise to $60 within one year. You're also willing to sell at $55 within six months,giving up further upside while taking ashort-term profit. In this scenario, selling a covered call on the position might be an attractive strategy.
The stock's option chainindicates that selling a $55six-month call option will costthe buyer a $4 per share premium. You could sell that optionagainst your shares, which you purchased at $50, and hopeto sell at $60 within a year. Writing this covered call creates an obligation to sell theshares at $55 within six months if the underlying price reaches that level. Youget to keep the$4 in premiumplus the $55 from the share sale, for a total of $59, or an 18% returnover six months.
On the other hand,you'll incura $10 loss on theoriginal position if the stock falls to $40—the buyer will not exercise the option because they can buy the stock cheaper than the contract price. However, you get to keep the $4 premium from the sale of the call option, lowering the total loss from $10 to$6 per share.
| Bullish Scenario: Shares Rise to $60 and the Option Is Exercised | |
|---|---|
| January 1 | Buy XYZ shares at $50 |
| January 1 | Sell XYZ call option for $4—expires on June 30, exercisable at $55 |
| June 30 | Stock closes at $60—option is exercised because it is above $55 and you receive $55 for your shares. |
| July 1 | PROFIT: $5 capital gain+ $4 premium collected from sale of the option = $9 per share or 18% |
| Bearish Scenario: Shares Drop to $40 and the Option Is Not Exercised | |
|---|---|
| January 1 | Buy XYZ shares at $50 |
| January 1 | Sell XYZ call option for $4—expires on June 30, exercisable at $55 |
| June 30 | Stock closes at $40—option is not exercised, and it expires worthless because the stock is below the strike price (the option buyer has no incentive to pay $55/share when they can purchase the stock at $40). |
| July 1 | LOSS: $10 share loss—$4 premium collected from the sale of the option = $6 or -12%. |
Advantages of Covered Calls
Selling covered call options can help offset downside risk or add to upside return, taking the cash premium in exchange for future upside beyondthe strike price plus premium during the contract period. In other words, if XYZstock in the example closesabove $59, the seller earns less return than if theyheld the stock. However, if the stock ends the six-month periodbelow $59 per share, the sellermakes moremoney or losesless money than if the options sale hadn't taken place.
Risks of Covered Calls
Call sellers have to hold onto underlyingshares or contracts or they'll be holding naked calls, which have theoretically unlimited loss potential ifthe underlying security rises. Therefore, sellers need to buy back options positionsbefore expiration if theywant to sell shares or contracts, increasing transaction costs while lowering net gains or increasing net losses.
Frequently Asked Questions
What Are the Main Benefits of a Covered Call?
The main benefits of a covered call strategy are that it can generate premium income, boost investment returns, and help investors target a selling price above the current market price.
What Are the Main Drawbacks of a Covered Call?
The main drawbacks of a covered call strategy are the risk of losing money if the stock plummets (in which case the investor would have been better off selling the stock outright rather than using a covered call strategy) and the opportunity cost of having the stock "called" away and forgoing any significant future gains in it.
Is There a Risk If I Sell the Underlying Stock Before the Covered Call Expires?
Yes, this can be a huge risk, since selling the underlying stock before the covered call expires would result in the call now being "naked" as the stock is no longer owned. This is akin to a short sale and can generate unlimited losses in theory.
Should I Write a Covered Call on a Core Stock Position with Large Unrealized Gains That I Wish to Hold for the Long Term?
It might not be advisable to do so since selling the stock may trigger a significant tax liability. In addition, if the stock is a core position you wish to hold for the long term, you might not be too happy if it is called away.
The Bottom Line
You can use covered calls todecrease thecost basis or to gain income from shares or futures contracts. When you use one, you're adding a profit generator tostock or contract ownership.
Like any strategy, covered call writing has advantages and disadvantages. If used with the right stock, covered calls can be a great way to reduce your average cost or generate income.
