Covered Calls: How They Work and How to Use Them in Investing

Covered Call

Investopedia / Alex Dos Diaz

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.

Key Takeaways

  • 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.

Covered Call

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 on 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.

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. Similarly, if an investor is very bearish, they may be better off simply selling the stock, since the premium received for writing a call option will do little to offset the loss on the stock if the stock plummets.

Covered Call
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Special Considerations

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.

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.

Article Sources
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  1. Fidelity. "Selecting a Strike Price and Expiration Date."

  2. Charles Schwab. "Options Strategies: Covered Calls & Covered Puts."

  3. Fidelity. "Why Use a Covered Call?"

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