What is a Covered Call?
A covered call is an options strategy you can use to reduce risk on your long position in an asset by writing call options on the same asset. Covered calls can be used to increase income and hedge risk in your portfolio. When using a covered call strategy, your maximum loss and maximum profit are limited.
- A covered call strategy involves writing call options against a stock the investor owns to generate income and/or hedge risk.
- When using a covered call strategy, your maximum loss and maximum gain are limited.
- Sellers of covered call options are obligated to deliver shares to the purchaser if they decide to exercise the option.
- The maximum loss on a covered call strategy is limited to the price paid for the asset, minus the option premium received.
- The maximum profit on a covered call strategy is limited to the strike price of the short call option, less the purchase price of the underlying stock, plus the premium received.
Basics of a Covered Call Strategy
When selling a call option, you are obligated to deliver shares to the purchaser if they decide to exercise their right to buy the option. For example, suppose you sell one XYZ call option contract with a strike price of $15, expiring next week. If the stock price closes above $15 at the expiration date, you would have to deliver 100 shares of XYZ to the buyer of the option.
The seller of a covered call gets paid a premium in exchange for giving up a portion of future potential upside.
Determining the Maximum Loss on a Covered Call Strategy
The maximum loss on a covered call strategy is limited to what the investor’s stock purchase price minus the premium received for selling the call option.
Covered Call Maximum Loss Formula:
Maximum Loss Per Share = Stock Entry Price - Option Premium Received
For example, let’s say you are long 100 shares of stock in company TUV at a price of $10. You think the stock will rise to $15 in six months and are willing to sell the stock at $12. Assume you sell one TUV call option with a strike price of $12, expiring in six months, for $300 a contract. Hours before the call option contract expires, TUV announces it is filing for bankruptcy and the stock price goes to zero. You would lose $1,000 on your long stock position. However, since you received a premium of $300, your loss is $700. ($1,000 - $300).
Determining the Maximum Profit on a Covered Call Strategy
The maximum profit on a covered call position is limited to the strike price of the short call option, less the purchase price of the underlying stock, plus the premium received.
Covered Call Maximum Gain Formula:
Maximum Profit = (Strike Price - Stock Entry Price) + Option Premium Received
Suppose you buy a stock at $20 and receive a $0.20 option premium from selling a $22 strike price call. You then decide to maintain your position providing the stock price stays below $22 until the options expire. If the stock price moves to $23, you only profit up to $22, therefore, your maximum profit is $22 - $20 (intrinsic value) + $0.20 (premium value) = $2.20 per contract.