What Is a Covered Call?
The term covered call refers to a financial transaction in which the investor selling call options owns an equivalent amount of the underlying security. To execute this, an investor who holds a long position in an asset then writes (sells) call options on that same asset to generate an income stream. The investor's long position in the asset is the cover because it means the seller can deliver the shares if the buyer of the call option chooses to exercise.
- A covered call is a popular options strategy used to generate income in the form of options premiums.
- Investors only expect a minor increase or decrease in the underlying stock price for the life of the option when they execute a covered call.
- To execute a covered call, an investor holding a long position in an asset then writes (sells) call options on that same asset.
- Covered calls are often employed by those who intend to hold the underlying stock for a long time but do not expect an appreciable price increase in the near term.
- This strategy is ideal for investors who believe the underlying price will not move much over the near term.
Understanding Covered Calls
Covered calls are a neutral strategy, meaning the investor only expects a minor increase or decrease in the underlying stock price for the life of the written call option. This strategy is often employed when an investor has a short-term neutral view of the asset and for this reason, holds the asset long and simultaneously has a short position via the option to generate income from the option premium.
Simply put, if an investor intends to hold the underlying stock for a long time but does not expect an appreciable price increase in the near term then they can generate income (premiums) for their account while they wait out the lull.
A covered call serves as a short-term hedge on a long stock position and allows investors to earn income via the premium received for writing the option. However, the investor forfeits stock gains if the price moves above the option's strike price. They are also obligated to provide 100 shares at the strike price (for each contract written) if the buyer chooses to exercise the option.
Maximum Profit and Maximum Loss
The maximum profit of a covered call is equivalent to the premium received for the options sold, plus the potential upside in the stock between the current price and the strike price. Thus, if the $100 call is written on a stock trading at $10, and the writer receives a premium of $1.00, the maximum potential profit is the $1.00 premium plus a $10 appreciation of the stock.
The maximum loss, on the other hand, is equivalent to the purchase price of the underlying stock less the premium received. This is because the stock could potentially drop to zero, in which case all you would receive is the premium for the options sold.
If the investor simultaneously buys a stock and writes call options against that position, it is known as a buy-write transaction.
Advantages and Disadvantages of Covered Calls
An options writer can earn money by selling a covered call, but they lose the potential profits if the call goes into the money. However, the writer must be able to produce 100 shares for each contract if the call expires in the money. If they do not have enough shares, they must buy them on the open market, causing them to lose even more money.
Covering calls can limit the maximum losses from an options transaction, but it also limits the possible profits. This makes them a useful strategy for institutional funds and traders because it allows them to quantify their maximum losses before entering into a position.
Loss of Potential Upside
A covered call strategy isn't useful for very bullish or very bearish investors. Very bullish investors are typically better off not writing the option and just holding the stock. The option caps the profit on the stock, which could reduce the overall profit of the trade if the stock price spikes.
Pros and Cons of Covered Calls
Covered options limit the risks and potential downsides of an options contract.
Options writers can earn a reliable premium from a small price increase.
Options writers must be able to produce 100 shares for each call option that expires in the money.
If an investor is very bullish on a security, they can make more money from uncovered calls or buying the underlying security.
When to Use and When to Avoid Covered Calls
The best time to sell covered calls is when the underlying security has neutral to optimistic long-term prospects, with little likelihood of either large gains or large losses. This allows the call writer to earn a reliable profit from the premium.
Covered calls are not an optimal strategy if the underlying security has a high chance of large price swings. If the price rises higher than expected, the call writer would miss out on any profits above the strike price. If the price falls, the options writer could stand to lose the entire price of the security, minus the initial premium.
Example of a Covered Call
Let's say an investor owns shares of a hypothetical company called TSJ. Although the investor likes its long-term prospects and its share price, they feel the stock will likely trade relatively flat in the shorter term, perhaps within a couple of dollars of its current price of $25.
If they sell a call option on TSJ with a strike price of $27, they earn the premium from the option sale but, for the duration of the option, cap their upside on the stock to $27. Assume the premium they receive for writing a three-month call option is $0.75 ($75 per contract or 100 shares). One of two scenarios will play out:
- TSJ shares trade below the $27 strike price. The option will expire worthless and the investor will keep the premium from the option. In this case, by using the buy-write strategy they have successfully outperformed the stock. They still own the stock but have an extra $75 in their pocket less fees.
- TSJ shares rise above $27. The option is exercised, and the upside in the stock is capped at $27. If the price goes above $27.75 (strike price plus premium), the investor would have been better off holding the stock. Although, if they planned to sell at $27 anyway, writing the call option gave them an extra $0.75 per share.
Are Covered Calls a Profitable Strategy?
As with any trading strategy, covered calls may or may not be profitable. The highest payoff from a covered call occurs if the stock price rises to the strike price of the call that has been sold and is no higher. The investor benefits from a modest rise in the stock and collects the full premium of the option as it expires worthless. 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.
Are Covered Calls Risky?
Covered calls are considered relatively low risk. Covered calls, however, would limit any further upside profit potential if the stock continued to rise, and would not protect much from a drop in the stock price. Note that, unlike covered calls, call sellers that do not own an equivalent amount in the underlying shares are naked call writers. Naked short calls have theoretically unlimited loss potential if the underlying security rises.
Can I Use Covered Calls in My IRA?
Depending on the custodian of your IRA and your eligibility to trade options with them, yes. There are also certain advantages to using covered calls in an IRA. The possibility of triggering a reportable capital gain makes covered call writing a good strategy for either a traditional or Roth IRA. Investors can buy back the stock at an appropriate price without having to worry about tax consequences, as well as generate additional income that can either be taken as distributions or reinvested.
Is There Such a Thing as a Covered Put?
In contrast to call options, put options grant the contract holder the right to sell the underlying (as opposed to the right to buy it) at a set price. The equivalent position using puts would involve selling short shares and then selling a downside put. This, however, is uncommon. Instead, traders may employ a married put, where an investor, holding a long position in a stock, purchases a put option on the same stock to protect against depreciation in the stock's price.
The Bottom Line
A covered call is an options trading strategy that allows an investor to profit from anticipated price rises. To make a covered call, the call writer offers to sell some of their securities at a pre-arranged price sometime in the future. This strategy offers lower upsides than other options strategies, but also offers lower risk.