A covered call is an options trading strategy that involves an investor holding a long position in an underlying asset, such as a stock, while simultaneously writing (selling) call options on the same asset.
This approach aims to generate additional income from the premiums received by selling the call options. This is particularly attractive in a flat or moderately bullish (optimistic) market where the underlying stock's price isn't expected to move significantly.
The covered call strategy limits the investor's upside potential because if the stock price rises above the strike price, the investor is obligated to sell their shares at that strike price. However, the strategy does provide a limited risk reduction: the premium received from selling the call provides some buffer against potential losses if the stock price declines.
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 or 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.
- The call seller will sell the shares at the strike price and keep the premium if the covered call buyer exercises their right.
How a Covered Call Works
You're entitled to several rights as a stock or futures contract owner, including the right to sell the security at any time for the market price. Covered call writing sells this right to someone else in exchange for upfront cash. The buyer of the option gets the right to buy your security on or before the expiration date at a preset rate called 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 stock or one futures contract at the strike price. They can do so at any time on or before expiration. The option is considered "covered" if the seller of the call option also owns the underlying security because they can deliver the instrument without buying it on the open market at potentially unfavorable pricing.
Covered Call Example
In the chart below, the horizontal line is the security's price at expiration. The vertical line is the profit or loss potential. You can hover over the solid line to see the profit and loss at each expiration price for the scenario given.
Profiting From Covered Calls
The buyer pays the seller of the call option a premium for the right to buy shares or contracts at a preset future price called the strike price. The premium is a cash fee paid on the day the option is sold, and it's the seller's money to keep regardless of whether the option is exercised.
Thus, a covered call is most profitable if the stock rises 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.
The call seller will sell the shares at the strike price and keep the premium if the covered call buyer exercises their right, profiting from the difference in the price they paid for the share and the selling price plus the premium. However, the seller gives up the chance to profit further if the share price increases by selling the share at the strike price.
Best Time To Use a Covered Call
Covered calls can be an excellent tool for improving your returns, but they are best for specific market conditions and investor outlooks. Here are three ideal times to consider using a covered call:
1. When the Market is Neutral or Slightly Bullish
Covered calls are best done in a neutral or slightly bullish market environment where you expect the stock price to stay relatively stable or rise modestly. In these scenarios, the premium collected from selling the call option provides added income while the risk of the option being exercised remains moderate.
If the stock price does rise slightly but stays below the strike price, you keep both the premium and your stock, benefiting from a steady income stream without sacrificing your shares. If the stock price rises above the strike price, you are prepared to sell at that price, having already factored this outcome in your strategy.
2. When You Want to Generate Income from Existing Holdings
If you want to generate additional income without selling your stocks, covered calls are a good choice. This strategy allows you to collect premiums on the call options sold and can be particularly attractive for investors who are holding a stock for the long term and want to boost their income in the interim.
3. When You're Willing to Sell the Stock at a Target Price
A covered call can also be effective when you want to sell your stock at a prearranged price. By setting the strike price at or near your target selling price, you collect the premium upfront and stand ready to sell your shares when the market reaches your desired level.
This can be particularly beneficial if you want to exit a position gradually or if you want to take advantage of a specific price target. The call premium is a bonus if the stock is called away, adding to your overall return. Even if the stock doesn't reach the strike price, the premium earned provides a partial return on your investment.
When To Avoid Using a Covered Call Strategy
While covered calls can be a useful strategy for generating income and managing risk, there are certain scenarios where it might not be the best approach. Here are a couple of situations where you should probably avoid using a covered call strategy:
1. When You Expect a Significant Upward Movement in the Stock Price
If you believe that the stock price of your holdings is likely to increase significantly in the near future, a covered call strategy can limit your potential gains. Since selling a call option obligates you to sell your shares at the strike price if the option is exercised, any substantial rise in the stock price beyond this will cap your upside potential.
In a scenario where you anticipate a strong bullish trend, holding onto your shares without writing covered calls allows you to benefit fully from any price appreciation.
2. When Market Volatility is High
High market volatility can pose a significant risk to covered call strategies. Stock prices can swing widely, increasing the likelihood that the call options you sell will be exercised unexpectedly. In addition, in a volatile market, the premiums on call options tend to be higher, which might seem attractive.
However, the underlying risk of abrupt price movements means you could be forced to sell your shares at a lower price than expected or suffer losses if the stock declines significantly. If the stock's price falls sharply, the premium collected may not be enough to offset the loss on the underlying stock, resulting in an unfavorable outcome. A covered call might not provide adequate risk management in such environments, and alternative strategies should be considered.
Tip
Covered calls are most effective when you have a neutral to mildly bullish outlook, so using them in a strong bull market can result in opportunity costs.
Example of a Covered Call
Assume you buy XYZ stock for $50 per share, believing it will rise to $60 within one year. You're also willing to sell at $55 within six months, giving up further upside while taking a short-term profit. Selling a covered call on the position might be an attractive strategy in this scenario.
The stock's option chain indicates that selling a $55 six-month call option will cost the buyer a $4 per share premium. You could sell that option against the shares that you bought at $50 and hope to sell at $60 within a year. Writing this covered call creates an obligation to sell the shares at $55 within six months if the underlying price reaches that level. You get to keep the $4 in premium plus the $55 from the share sale for a total of $59 or an 18% return over six months.
But you'll incur a $10 loss on the original position if the stock falls to $40. The buyer won't exercise the option because they can buy the stock cheaper than the contract price. However, you keep the $4 premium from the sale of the call option, reducing 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%. |
Here's a chart depicting this scenario in action (hover over the line to see specific values):
Advantages and Disadvantages of Covered Calls
Generates immediate income
Offers some downside protection
Can improve existing holdings
Flexible and adjustable
Limits upside potential
Doesn't fully protect against downside losses
Requires stock ownership
Options trading involves transaction costs
Advantages of Covered Calls
Covered calls provide a way to improve the yield on a portfolio by collecting premiums from selling call options. This extra income can supplement dividends or other income generated by stock holdings.
Covered calls can also serve as a means to generate income while waiting for the stock to appreciate or stabilize in stagnant or slightly bearish market conditions when stocks may not be experiencing significant price appreciation.
In addition, they can act as a form of downside protection. Investors lower their cost basis in the underlying stock by receiving the premium from selling the call option. The premium received can offset some of the losses or provide a cushion against downside risk if the stock price remains flat or decreases slightly.
The seller earns less in return than if they held the stock if XYZ stock in the example closes above $59. But the seller makes more or loses less money than if the options sale hadn't occurred if the stock ends the six-month period below $59 per share.
Risks of Covered Calls
Call sellers have to hold onto underlying shares or contracts, or they'll be holding naked calls that theoretically have unlimited loss potential if the underlying security rises. Thus, Sellers must buy back options positions before expiration if they want to sell shares or contracts, increasing transaction costs while lowering net gains or losses.
Another risk of covered calls is the potential for loss if the stock price declines. The premium received from selling the call option provides some downside protection but may not fully offset losses if the stock price decreases a lot. The investor may incur losses on the stock position if the stock price falls below the breakeven point, which is the original purchase price minus the premium received.
What Are Naked Calls?
It's a naked call if the contract isn't a covered call. It's used to generate a premium without owning the underlying asset. This is considered to be the riskiest type of options contract because the underlying security could go up significantly in price. The seller of the option could be required to purchase the stock at a much higher price than the strike price if this happens.
How Are Options Different From Futures?
Both options and futures are types of derivatives contracts that are based on some underlying asset or security. The main difference is that options contracts grant the right but not the obligation to buy or sell the underlying in the future. Futures contracts have this obligation.
Is There a Risk If I Sell the Underlying Stock Before the Covered Call Expires?
Yes, this can be a huge risk. Selling the underlying stock before the covered call expires would result in the call now being "naked" because 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 Want to Hold for the Long Term?
It's typically not advisable because selling the stock may trigger a significant tax liability. And you might not be too happy if it's called away if the stock is a core position you want to hold for the long term.
The Bottom Line
You can use covered calls to decrease the cost basis or to gain income from shares or futures contracts. You're adding a profit generator to stock or contract ownership when you use one.
Like any strategy, covered call writing has advantages and disadvantages. Covered calls can be a great way to cut your average cost or generate income if they're used with the right stock at the right time.
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