The Basics of Covered Calls

Professional market players write covered calls to boost investment income, but individual investors can also benefit from this conservative but effective option strategy by taking the time to learn how it works and when to use it. In this regard, let's look at the covered call and examine ways it can lower portfolio risk and improve investment returns.

Key Takeaways

  • A covered call is a popular options strategy used to generate income from 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 will also not offer much protection if the price of the stock drops.
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Covered Call

What Is a Covered Call?

You are 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 cash, meaning the buyer of the option gets the right to own your security on or before the expiration date at a predetermined price called the strike price.

A call option is a contract that gives the buyer the legal right (but not the obligation) to buy 100 shares of the underlying stock or one futures contract at the strike price any time on or before expiration. If the seller of the call option also owns the underlying security, the option is considered "covered" because they can deliver the instrument without purchasing it on the open market at possibly unfavorable pricing.

Profiting from Covered Calls

The buyer pays the seller of the call option a premium to obtain the right to buy shares or contracts at a predetermined future price. The premium is a cash fee paid on the day the option is sold and is the seller's money to keep, regardless of whether the option is exercised or not. A covered call is therefore most profitable if the stock moves up to the strike price, generating profit from the long stock position, while the call that was sold expires worthless, allowing the call writer to collect the entire premium from its sale.

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When to Sell a Covered Call

When you sell a covered call, you get paid in exchange for giving up a portion of future upside. For example, let's 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. In this scenario, selling a covered call on the position might be an attractive strategy.

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 your shares, which you purchased 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 the grand total of $59, or an 18% return over six months.

On the other hand, you'll incur a $10 loss on the original position if the stock falls to $40. 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 stock is below 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 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 beyond the strike price plus premium during the contract period. In other words, if XYZ stock in the example closes above $59, the seller earns less return than if they simply held the stock. However, if the stock ends the six-month period below $59 per share, the seller makes more money or loses less money than if the options sale hadn't taken place.

Risks of Covered Calls

Call sellers have to hold onto underlying shares or contracts or they'll be holding naked calls, which have theoretically unlimited loss potential if the underlying security rises. Therefore, sellers need to buy back options positions before expiration if they want to sell shares or contracts, increasing transaction costs while lowering net gains or increasing net losses.

What Are the Main Benefits of a Covered Call?

The main benefits of a covered call strategy are that it can generate premium income and boost investment returns, and help investors target a selling price that is 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 that you wish to hold for the long term, you might not be too happy if it is called away.

The Bottom Line

Use covered calls to decrease the cost basis or to gain income from shares or futures contracts, adding a profit generator to stock 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.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. U.S. Securities and Exchange Commission. "Investor Bulletin: An Introduction to Options."

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