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.

What are Covered Calls?

Covered calls are a common investment strategy. This strategy involves owning stocks and selling call options on them. By selling call options, investors earn extra income from option premiums while maintaining ownership of the stocks. When they sell call options, investors agree to sell their shares at a set price, known as the strike price, if the buyer exercises the option before it expires. This strategy works best when investors expect stock prices to remain stable or rise slightly. However, it can limit potential gains if the stock price rises significantly above the strike price. Next, we will explore how covered calls operate, their advantages and disadvantages, and tips for using this strategy effectively.

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.

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.

Theoretical 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 Avoid 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.

Advantages of Covered Calls

Covered calls are a popular investment strategy. They can enhance income and reduce risk for stock investors. This strategy involves owning shares of a stock and selling call options for that same stock. Investors earn premium income from the options, which can help offset losses or increase returns. Covered calls are attractive to those wanting to profit from short-term price changes while keeping their stocks. However, this strategy has downsides. It can limit potential gains. In the following sections, we will discuss the main benefits and factors to consider when using covered calls in your investment portfolio.

Hedged Position

If the price of the underlying stock goes up, an investor can reduce potential losses on the sold call option. This happens because the gains from owning the stock can help balance out any losses from the call options. Essentially, when the stock price rises, it offers protection against the decrease in value of the sold call, improving overall portfolio stability.

Relatively Lower Risk

The covered call strategy provides a more cautious way to invest compared to just holding stocks or writing naked calls. By owning the underlying stock and selling call options, this strategy offers some protection against drops in the stock price. This can be especially useful in unstable markets, helping investors reduce certain risks while still allowing for potential gains.

Ease of Implementation

The covered call strategy is easy to set up and execute. Investors must own shares of the stock they want to cover. They then sell call options against those shares. This simplicity makes the strategy accessible to many investors. Both experienced and newer options traders can use it. The strategy allows for quick implementation in different market conditions. It does not require complex calculations or strategies.

Risks of Covered Calls

Covered calls are a popular strategy for investors seeking extra income from their stocks. By selling call options on shares they own, investors earn premium payments while keeping their stocks. However, this strategy carries risks. One major risk is limited upside potential. If the stock price exceeds the strike price, investors may lose out on profits. There is also the obligation to sell shares if the options are exercised. Market fluctuations, dividend payments, and time decay can impact results. Investors should carefully evaluate these risks to determine if covered calls align with their investment goals and risk tolerance.

Loss of Potential Upside

Selling covered calls has some significant risks. One major risk is the potential loss of upside. When you sell a call option against your stock, you agree to sell your shares at the strike price if the option is exercised. In a bullish market, where stock prices increase sharply, this strategy limits your profit potential. If the stock price rises above the strike price, you will miss out on additional gains. This effectively caps your profit.

100 Shares Required per Call

A standard call option contract corresponds to 100 shares of the stock. Therefore, to implement a covered call strategy, you need to own a minimum of 100 shares. This requirement may restrict investors with smaller portfolios or those wanting to diversify from effectively using this strategy.

Requirement for Additional Capital

Using a covered call strategy usually requires extra capital. Besides the money needed to buy the underlying shares, investors also need to consider the margin requirements for selling the call option. This capital commitment can be considerable, particularly in volatile markets where margin requirements may rise.

Generates Taxable Income

Selling a call option results in taxable income, impacting your overall tax liability. The premiums earned from the sale are classified as short-term capital gains and taxed at your ordinary income rate. This tax effect may reduce the overall profitability of the strategy, especially for investors in higher tax brackets.

Downside Risk Arises From Stock Ownership

Selling a call option can generate some income. However, it does not remove the risks of owning the underlying stock. If the stock price goes down, you can still incur losses from your long position. The premium from selling the call option may help reduce some of these losses. Still, it does not fully protect against downside risk. It is important to evaluate the stock's potential volatility and market conditions before using this strategy.

Should You Use Covered Calls for Options Trading?

Covered calls can be a useful strategy in options trading, providing income opportunities and risk management benefits. By selling call options on shares they own, investors can earn premium income while possibly reducing losses in flat or slightly rising markets. This strategy is effective when market conditions are steady, enabling investors to take advantage of time decay and lower their overall investment cost.

It's important to recognize the possible drawbacks. If the stock price rises above the strike price, your shares might be taken, limiting your profit potential. Also, covered calls may not work as well in volatile markets, where quick price changes can reduce profits.

It's important to understand market conditions and your investment goals before using a covered call strategy. This approach may be beneficial for investors focused on income in stable markets, but those looking for substantial capital growth may find it restrictive. Considering these factors carefully can help you decide if covered calls are a suitable investment strategy for you.

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