How and Why to Use a Covered Call Option Strategy
The risks and reward of using Covered Calls
A covered call is an options strategy that involves both stock and an options contract. The trader buys (or already owns) a stock, then sells call options for the same amount (or less) of stock, and then waits for the options contract to be exercised or to expire.
If the options contract is exercised (at any time for US options, and at expiration for European options) the trader will sell the stock at the strike price, and if the options contract is not exercised the trader will keep the stock.
For a covered call, the call that is sold is typically out of the money (OTM). This allows for profit to be made on both the options contract and the stock if the stock price stays below the strike price of the OTM option. If you believe the stock price is going to drop, but you still want to maintain your stock position for the time being, you can sell an in the money call option (ITM). For this you will receive a higher premium on your option trade, but the stock must fall below the ITM option strike price, otherwise the buyer of your option will receive your shares if the share price is above the strike price at expiration (you lose your share position). This is discussed in more detail in the Risk and Reward section below.
How to Create a Covered Call Trade
- Purchase a stock, and only buy it in lots of 100 shares.
- Sell a call contract for each 100 shares of stock you own. One contract represents 100 shares of stock. If you own 500 shares of stock, you can sell up to 5 call contracts against that position. You can also sell less than 5 contracts, which means if the call options are exercised you will retain part of your stock position. In this example, if you sell 3 contracts, and the price is above the strike price at expiration, 300 of your shares will be called away, but you will still have 200 remaining.
- Wait for the call to be exercised or to expire. You are making money off the premium the buyer of the option is paying you. If the premium is $0.10 per share, you make that full premium if you hold option until expiration and it is not exercised. You can buy back the option before expiry, but there is little reason to do so, and thus isn't usually part of the strategy.
Risks and Rewards of the Covered Call Options Strategy
As shown on the risk/reward chart (view the full size chart), the risk of a covered call comes from holding the stock position, which could drop.
Your maximum loss occurs if the stock goes to zero. Therefore, you maximum loss per share is:
(Stock Entry Price - $0) + Option Premium Received
For example, if you buy a stock at $9, and receive a $0.10 option premium on your sold call, your maximum loss is $8.90 per share. The option premium reduces your maximum loss, relative to just owning the stock.The income from the option premium comes at a cost though, as it also limits your upside on the stock.
You can only profit on the stock up to the strike price of the options contracts you sold. Therefore, your maximum profit is:
(Strike Price - Stock Entry Price) + Option Premium Received
For example, if you buy a stock at $9, receive a $0.10 option premium from selling a $9.50 strike price call, then you maintain your stock position as long as the stock price stays below $9.50 at expiration. If the stock price moves to $10, you only profit up to $9.50, so your profit is $9.50 - $9.00 + $0.10 = $0.60.
If you sell an ITM call option, the price will need to fall below the strike price in order for you to maintain your shares.
If this occurs, you will likely be facing a loss on your stock position, but you will still own your shares, and you will have received the premium to help offset the loss.
Final Word on the Covered Call Options Strategy
The main goal of the covered call is to collect income via option premiums by selling calls against a stock that is already owned. Assuming the stock doesn't move above the strike price, the trader collects the premium and is allowed to maintain the stock position (which can still profit up to the strike price).
Traders need to factor in commission when trading a covered call. If commissions will erase a significant portion of the premium received, then it isn't worth while selling the option(s) and creating a covered call.
Covered call writing is typically used by investors and longer-term traders, and is rarely used by day traders.