What Is a Covered Call?

July 27, 2023
10 MIN READ
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In the world of options trading, one popular strategy that both seasoned and novice investors employ is the covered call. This strategy involves a combination of owning a specific asset, typically stocks, and selling call options against those holdings. By executing a covered call, investors can generate income while potentially benefiting from the price appreciation of their underlying assets. In this article, we will delve into the intricacies of covered calls, exploring their mechanics, advantages, and potential risks.

Understanding Covered Calls

A covered call is a multi-legged options strategy where an investor owns the underlying asset (e.g., stocks) and simultaneously sells call options on that asset. The investor, known as the writer of the call option, receives a premium from the buyer in exchange for granting them the right to buy the underlying asset at a predetermined price (the strike price) within a specified timeframe (the expiration date). In return for the premium, the writer assumes the obligation to sell the underlying asset if the buyer exercises the call option.

Mechanics of a Covered Call

Let's break down the mechanics of a covered call using an example. Suppose an investor owns 100 shares of XYZ Company, currently trading at $50 per share. The investor decides to sell one call option contract with a strike price of $55 and an expiration date one month from now. In exchange for selling the call option, the investor receives a premium of $2 per share, totaling $200 ($2 × 100 shares).

Advantages of Covered Calls

Income generation: The primary advantage of covered calls is the ability to generate income. By selling call options, investors receive premiums, which can enhance their overall returns, especially in flat or mildly bullish markets.

Reduced cost basis: The premium received from selling call options can lower the average cost basis of the underlying asset. This can provide a cushion against potential price declines, reducing the overall risk associated with holding the asset.

Upside potential: While investors cap their potential gains when selling covered calls, they can still benefit from the underlying asset's appreciation up to the strike price. If the asset's price surpasses the strike price, the investor will profit from the price increase while keeping the premium.

Portfolio hedging: Covered calls can act as a form of portfolio protection. If the price of the underlying asset decreases, the premium received from selling call options can offset some of the losses, cushioning the downside risk.

Risks and Considerations

Limited upside potential: By selling call options, investors cap their potential gains if the price of the underlying asset surges above the strike price. If the asset is called away, the investor will miss out on any further upside potential.

Stock price decline: While covered calls provide some downside protection, they do not eliminate the risk of price declines in the underlying asset. If the price of the asset decreases significantly, the premium received from selling the call options may not be sufficient to offset the losses. Investors should carefully consider their risk tolerance and the potential impact of a declining stock price.

Obligation to sell: By writing covered calls, investors obligate themselves to sell the underlying asset if the buyer exercises the call option. This can result in missing out on potential future gains if the asset appreciates significantly.

Opportunity cost: Selling covered calls limits the potential gains beyond the strike price. If the price of the underlying asset surges well above the strike price, the investor will only profit up to that point, missing out on additional gains that could have been achieved if the asset was not encumbered by the call option.

Time decay: Options contracts have a limited lifespan, and their value tends to diminish as they approach their expiration dates. This phenomenon, known as time decay, can impact the profitability of covered calls, especially if the underlying asset's price remains relatively unchanged.

Market risk: Covered calls are subject to overall market risks. Unforeseen market events, economic factors, or company-specific news can impact the price of the underlying asset, potentially affecting the profitability of the covered call strategy.

Maximum Profit and Maximum Loss

Maximum Profit in Covered Calls:

The maximum profit potential in a covered call strategy is achieved when the price of the underlying asset remains below the strike price of the call option until expiration. In this scenario, the call option expires worthless, and the writer of the option keeps the premium received from selling the call option. The maximum profit is calculated by adding the premium received from selling the call option to any dividends received from owning the underlying asset.

For example, let's say an investor sells a covered call option on 100 shares of XYZ Company at a strike price of $55 for a premium of $2 per share, totaling $200. Additionally, during the holding period, the investor receives $50 in dividends from owning the 100 shares of XYZ Company. If the call option expires worthless, the investor's maximum profit would be $200 (premium) + $50 (dividends) = $250.

Maximum Loss in Covered Calls:

The maximum loss in a covered call strategy occurs when the price of the underlying asset significantly declines. This loss is limited to the difference between the purchase price of the underlying asset and the strike price of the call option, minus the premium received from selling the call option.

Continuing with the previous example, suppose the investor purchased the 100 shares of XYZ Company for $50 per share, resulting in a total investment of $5,000. If the price of the underlying asset drops below the strike price of $55, the investor would start to incur losses. The maximum loss would occur if the price of the underlying asset goes to zero. In this case, the investor's loss would be limited to $500 (difference between the purchase price and strike price) - $200 (premium received) = $300.

It is important to note that the maximum loss is limited in a covered call strategy because the investor owns the underlying asset, which provides a cushion against significant losses. However, it is crucial to carefully consider the potential downside risk and the impact it may have on the overall investment portfolio.

Managing Covered Call Positions

Investors can actively manage their covered call positions to mitigate potential losses or maximize profits. Some common management techniques include:

Rolling the call option: If the price of the underlying asset approaches or exceeds the strike price, investors may choose to "roll" the call option by buying back the current call option and simultaneously selling a new call option with a later expiration date or a higher strike price. This allows the investor to generate additional premium and potentially participate in future upside potential.

Buying back the call option: If the price of the underlying asset significantly increases and the call option is in-the-money, the investor may decide to buy back the call option to avoid the risk of having the underlying asset called away. This allows the investor to retain ownership of the asset and potentially benefit from further price appreciation.

Allowing exercise: If the investor is willing to sell the underlying asset at the strike price, they can choose to allow the call option to be exercised. This results in the sale of the asset at the predetermined price and the realization of the maximum profit.

When to Use and When to Avoid Covered Calls

When to Use Covered Calls:

Income generation: Covered calls are suitable for investors looking to generate additional income from their existing stock holdings. By selling call options against the underlying assets, investors can collect premiums, which can supplement their investment returns, particularly in sideways or mildly bullish markets.

Moderate bullish outlook: Covered calls can be beneficial when an investor has a moderately bullish outlook on the underlying asset. It allows them to participate in potential price appreciation up to the strike price while receiving premium income.

Portfolio hedging: Utilizing covered calls can act as a form of portfolio protection. By selling call options, investors can mitigate potential losses if the price of the underlying asset decreases. The premium received from selling the options provides a buffer against downside risks.

Exit strategy: Covered calls can serve as an exit strategy for investors looking to sell their holdings at a specific price. By selling call options at a strike price they are willing to sell the asset, investors can ensure a predetermined profit if the options are exercised.

When to Avoid Covered Calls:

Strong bullish outlook: If an investor has a highly bullish outlook on the underlying asset and believes it has significant potential for price appreciation, employing covered calls may limit their upside potential. Selling call options caps the profit potential beyond the strike price, preventing participation in substantial price gains.

Limited downside protection: While covered calls provide some downside protection, they may not be sufficient in volatile or bearish market conditions. If the price of the underlying asset declines significantly, the premium received from selling the call options may not fully offset the losses incurred.

Illiquid options market: Covered calls require a liquid options market to ensure ease of trading and fair pricing. If the options market for the underlying asset is illiquid, it may result in wider bid-ask spreads, making it less favorable for executing covered call strategies.

Emotional attachment: Investors should avoid using covered calls if they have a strong emotional attachment to the underlying asset. Selling call options may result in the asset being called away, potentially causing regret or missed opportunities if the asset continues to appreciate.

Lack of understanding: It is crucial to have a solid understanding of options trading and the mechanics of covered calls before employing this strategy. If an investor is unfamiliar with options or lacks the knowledge to evaluate risk and reward, it is advisable to seek education or professional guidance before engaging in covered call trading.

Are Covered Calls a Profitable Strategy?

Covered calls can be a profitable strategy under certain market conditions and when properly executed. However, it is important to note that profitability depends on various factors, including market conditions, stock selection, strike price selection, and the investor's ability to manage the position effectively.

The profitability of covered calls primarily comes from the premiums received when selling call options. If the price of the underlying asset remains below the strike price until expiration, the call options expire worthless, allowing the investor to keep the premium as profit. In this scenario, the investor can generate income in addition to any dividends received from owning the underlying asset.

Additionally, covered calls offer the potential for profit if the price of the underlying asset increases but remains below the strike price. In this case, the investor retains ownership of the asset and keeps the premium received, resulting in a net profit.

However, it is important to recognize that covered calls have limitations that can impact profitability. One limitation is the potential opportunity cost if the price of the underlying asset rises significantly above the strike price. In this situation, the investor's potential gains are limited to the strike price, missing out on further price appreciation.

Moreover, if the price of the underlying asset declines substantially, the premium received from selling the call options may not fully offset the losses. The investor may experience a net loss, although it is limited by the cushion provided by owning the underlying asset.

The profitability of covered calls also depends on the investor's ability to effectively manage the position. Active management, such as rolling the call options or adjusting the strategy based on market conditions, can help optimize profitability and mitigate potential losses.

It is essential to thoroughly research and understand the risks and rewards associated with covered calls before employing this strategy. Market conditions, stock selection, strike price selection, and effective management are critical factors that can impact the profitability of covered calls. Investors should consider their individual goals, risk tolerance, and market outlook when deciding whether to use covered calls as part of their investment strategy. Seeking professional advice or education on options trading can also be beneficial for enhancing profitability and managing risk effectively.

Is There Such a Thing as a Covered Put?

No, there is no strategy known as a "covered put." The concept of a covered position typically applies to call options, where an investor owns the underlying asset and sells call options against it. In this case, the investor has a covered call position.

However, a put option is a different type of options contract that gives the holder the right, but not the obligation, to sell the underlying asset at a specified price within a specific timeframe. It provides downside protection or can be used to speculate on a potential price decline in the underlying asset.

If an investor owns the underlying asset and also sells put options against it, it is commonly referred to as a "cash-secured put" strategy. In this strategy, the investor is willing to buy more of the underlying asset at a predetermined price (the strike price) if the options are exercised. This approach allows the investor to collect premiums from selling the put options and potentially acquire more of the asset at a lower price.

While the covered call strategy is a popular and widely used options strategy, the covered put strategy is not commonly referred to as a specific strategy. Investors interested in utilizing options, including put options, should familiarize themselves with the characteristics, risks, and potential rewards associated with each strategy and consult with a financial advisor or options trading professional for further guidance and understanding.

Conclusion

Covered calls are a popular options strategy employed by investors seeking to generate income and potentially benefit from modest price appreciation in their underlying assets. By understanding the mechanics, advantages, and risks associated with covered calls, investors can make informed decisions and utilize this strategy to enhance their investment portfolios. As with any investment strategy, it is crucial to conduct thorough research, assess individual risk tolerance, and consider market conditions before implementing covered calls or any options trading strategy.