What Are Covered Calls?

Covered calls are an option trading strategy where an investor holds a long position in an asset and sells call options on that same asset to generate income. The "covered" aspect of the strategy refers to the fact that the investor already owns the underlying asset, which can offset the risk of being short calls on the upside. This makes covered calls a relatively lower-risk options strategy. This article will use stocks as the underlying asset as an example.

 How Covered Calls Work

A covered call strategy typically refers to owning stock and selling a call option against it. A call option is a contract that gives the buyer the right, but not the obligation, to purchase the stock at a specified price (strike price) by or on a certain date (expiration date). By selling call options, the investor collects a premium that serves as income.

Theoritical Maximum Profit and Maximum Loss

The maximum profit occurs when the stock price stays the same or rises slightly. The option contract multiplier is typically 100 shares per contract. 

Maximum profit = (Strike price - stock price) + call premium 

For example paying $50 for stock and selling a $55 strike call at $2, the maximum profit could be ($55-50)+$2 = $7 per option contract

Maximum loss occurs if the stock price drops significantly. If the $50 stock drops to $0, the investor loses $50*100=$5000 and gains only the $2*100 = $200 call premium.

When to Consider Covered Calls

Covered calls can be a useful strategy if you have a positive outlook on a stock's potential for long-term growth but also want to generate income from your holdings. The strategy can be particularly effective when you believe that the stock is likely to remain within a certain price range or grow gradually over time. By selling a call option, you can earn income.

When to Consider Avoiding Covered Calls

When you are pessimistic about a stock you own and believe the price will fall, you should consider avoiding  covered calls. In this case, selling call options would likely result in a loss on the stock that the call premium might not offset. 

Covered Call vs. Covered Put

Covered calls and covered puts are similar limited-risk option strategies. While covered calls usually involve buying a stock and selling a call, a covered put involves buying stock and buying a put to protect against downside. A put gives the buyer the right to sell the underlying stock at a predetermined strike price by or on a given expiration date.

Potential Advantages of a Covered Call

Investors use covered calls to obtain the following benefits: 

• Hedged position: When the stock price is rising, losses on the call are limited because profits from being long stock may offset the potential losses from selling the call options. 
• Relatively lower risk: Compared to being purely long stock or purely short calls, the strategy has relatively lower risks from being somewhat hedged on the downside. 
• Relatively simple to set up: The covered call strategy is simple to set up and execute, making it possible to trade for both experienced and inexperienced investors.

Risks of a Covered Call

All strategies have risks — here are some of the key downsides to pay attention to: 

• Loss of potential upside: In a market where the stock price is rising, you limit the profit potential when selling call options when you own the stock.
• 100 shares required per call: One call option contract usually equates to 100 underlying shares.  
• Need for more capital: The margin requirements for executing a covered call strategy may require additional capital to cover both the cost of purchasing the stock and selling the call option.
• Generates taxable income: Selling a call option creates taxable income.
• Downside risk comes from owning the stock : If you’ve sold a call option, you have to  to keep a long stock position to cover the open short call option. 

Example of a Covered Call

Say you own 100 shares of a stock that is currently trading at $50 per share. You decide to sell one call option at a strike price of $55, receiving a premium of $2 per contract. If the stock price stays at $50 or drops, the option will expire worthless, and you will keep the $200 premium ($2 x 100 shares). However, you will miss out on any potential gains in the stock price above $55.

But if the stock price rises above $55, the option buyer will exercise the right to purchase the shares at $55. In this case, you will sell the stock for $55 per share, giving you a $5 gain per share ($55 - $50), for a total of $500 ($5 x 100 shares). While you will miss out on any potential gains above $55, you still receive the $200 premium, making your total gain $700 ($500 + $200).

In the above example if the stock drops to $45 per share, you will still collect the premium of $2 per contract but lose $5 per share on your long stock position. If you own 100 shares of stock your loss will be $200-500 = $300.

Learn About Covered Calls

Covered calls may be a limited and income-generating investing technique. Investors who have a neutral to long term bullish outlook may sell calls against stock holdings to generate income. However, it is critical to recognize the risks involved with covered calls, which include possible loss on the stock, additional capital needs and additional taxable income. Consider carefully whether covered calls are an appropriate investment strategy before you trade.

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