A covered call is a popular options strategy used to generate income from writing (selling) options.
To perform a covered call, an investor holds shares of stock in a company and then “writes” (or sells) another investor the option to buy the stock at a price higher than the current value of the stock. The payment the investor receives for selling the option is called the premium, and is the income the investor receives for writing the option.
The strategy is called “covered” because the investor owns the stock in their portfolio and can deliver the shares if the option buyer executes the options. This is in contrast to selling call options without owning the stock, which is called a naked call as the investor is exposed to delivering the shares of the stock at the market price.
Disclaimer: Before we get into the details you should know that stock options and option strategies involve higher levels of risk and should be used by advanced investors who understand options and their risk.
How a covered call works
Entering into a covered call position
There are two ways for an investor to get into a covered call position.
- Owning the stock already and writing the call options
- Buy-write trade
Writing covered calls options on stock already held
If an investor already owns the stock, the investor sells call options for the same stock that they already own. The investor then chooses the strike price and the expiration date for the options to be written. An investor can write 1 option contract for every 100 shares of stock owned (because 1 option contract entitles the owner to 100 shares).
Buy-write trade
If the investor wants to enter into a covered call strategy but does not already own the stock, the investor can perform a buy-write trade. In a buy-write trade the investor buys shares of a stock and simultaneously writes call options for the same stock. The investor buys 100 shares for every 1 option contract written.
Understanding covered calls
If the stock price remains below the option strike price at expiration date, then the option expires worthless. The investor gets to keep the option premium and the shares of the stock. The option buyer receives nothing as their options expire worthless. Their purchase of the call options was a complete loss.
If the stock price exceeds the option strike price, the option buyer/owner will execute the option. Meaning that they will purchase shares of the stock from the investor / option writer at the option strike price (even though it’s lower than the market price of the stock). The option buyer will receive 100 shares for every option contract purchased. The investor / option writer will sell the shares they already own in their account.
Maximum profit / loss from covered call
The maximum profit an investor can gain from a covered call is limited to the premium the investor receives for writing the option. This happens when the option expires worthless.
When writing a covered call the investor’s risk lies in the stock being held to cover the option during the period until expiration. The maximum loss an investor could incur is the total value of the stock held (if it declines to $0), less the option premium which the investor keeps regardless. Declines in the stock price can can easily exceed the option premium the investor received, so there is substantial risk to this strategy.
The breakeven point can be calculated by subtracting the option premium from current stock price and adding back in any commissions. The covered call breakeven formula is:
Current stock price – option premium + commission / number of shares
Additionally, the other downside to a covered call is the investor loses out on the opportunity for additional gains of the stock they hold. Their potential gains for their stock position holding are limited to the strike price set at option sale as they will be required to sell the stock at that price. Any stock price appreciation beyond that will benefit the option buyer.
Covered call example
In this example an investor owns 100 shares of a hypothetical publicly traded company AIV (Accessible Investor). AIV is currently trading at $27 per share. The investor already owns the stock for some time and thinks the stock will appreciate over the long-term but does not expect the stock to change in price in the next few months.
The investor writes (sells) 1 call option contract with a strike price of $30 and is three weeks until expiration, because they don’t think the stock price will increase that much in three weeks. The call option contract is written for $1.20, so the investor receives a premium of $120 total (1 option contract equals 100 shares, so $1.20 * 100 = $120).
From here, one of two things can happen:
Options expire worthless
Let’s say that the stock price increases to $28 over the three weeks when the option expires. Because the stock price ($28) is still less than the call option strike price ($30), the option expires worthless. The investor keeps the $120 premium and the option buyer does not gain anything.
Options go into the money
However, if the stock price increases to $32 by the time the option expires, then the options are considered “in the money” and then the option buyer will “execute” the call option. Executing a call option means that the option owner buys the stock at the agreed to price (the strike price, $30 in our example).
The option buyer / owner will pay $30 per share for 100 shares of AIV stock, for a total of $3,000. The investor who wrote the option already owns $100 shares of the stock and is obligated to sell the stock to the option owner for $30, even though the stock is trading at $32 on the market. The investor still gets to keep the $120 premium for the options, but will no longer get to benefit from increases in the price of the stock.
It’s important to note that at $32 a share, the investor is worse off on this trade because even though they get to keep the $120 premium, they lost out on $200 in stock price appreciation. This is because they were obligated to sell the 100 shares at $30 a share rather than $32 on the market ($2 difference * 100 shares = $200). If they had not sold the option contract they would have been better off by $80 in this example.
Infographic: How a covered call option strategy works
Covered call strategy
A covered call option strategy is considered a neutral strategy, meaning the investor doesn’t believe the stock price will change much in the near term. It’s often used by investors who believe in the long-term prospects of the stock but does not expect the price to move much in the short-term. The investor is expecting the stock price to remain below the strike price by the time the option expires.
Investors generally use covered call strategies for two purposes: generating income or reducing the purchase price of a stock.
Generate income
Investors can generate income by writing covered calls against stocks they already hold in their portfolio. If the options expire worthless, the investor retains the shares and can repeat the process indefinitely, continuing to generate income from the option premiums.
Reduce purchase price of stock
Some investors use a covered call strategy to effectively reduce the purchase price of a stock by using a buy-write trade to get into a covered call position. By writing call options at the same time of stock purchase, the investor essentially offsets the stock purchase price by a small amount with the option premium.
Summary
Covered calls are a popular options strategy to generate income. However, there is significant risk to this and any option strategy that involves writing options. If using a covered call strategy remember that the risk lies in holding the stock itself for extended periods of time while limiting your upside. For that reason, the placement of the strike price and option expiration should be carefully considered.
Have you used covered call options strategy? How did it work for you?
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