How and Why to Use a Covered Call Option Strategy
A covered call is an options strategy involving trades in both the underlying stock and an options contract. The trader buys or owns the underlying stock or asset. They will then sell call options (the right to purchase the underlying asset, or shares of it) and then wait for the options contract to be exercised or to expire.
Exercising the Option Contract
If the option 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 option contract is not exercised the trader will keep the stock.
A put option is the option to sell the underlying asset, whereas a call option is the option to purchase the option. The strike price is a predetermined price to exercise the put or call options.
For a covered call, the call that is sold is typically out of the money (OTM), when an option's strike price is higher than the market price of the underlying asset. This allows for profit to be made on both the option contract sale and the stock if the stock price stays below the strike price of the option.
If you believe the stock price is going to drop, but you still want to maintain your stock position, you can sell an in the money (ITM) call option, where the strike price of the underlying asset is lower than the market value.
When selling an ITM call option, you will receive a higher premium from the buyer of your call option, but the stock must fall below the ITM option strike price—otherwise, the buyer of your option will be entitled to receive your shares if the share price is above the option's strike price at expiration (you then lose your share position). Covered call writing is typically used by investors and longer-term traders, and is used sparingly by day traders.
How to Create a Covered Call Trade
There are some general steps you should take to create a covered call trade.
- Purchase a stock, buying it only in lots of 100 shares.
- Sell a call contract for every 100 shares of stock you own. One call 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 won't have to relinquish all of your stock position. In this example, if you sell 3 contracts, and the price is above the strike price at expiration (ITM), 300 of your shares will be called away (delivered if the buyer exercises the option), but you will still have 200 shares remaining.
- Wait for the call to be exercised or to expire. You are making money off the premium the buyer of the call option pays to you. If the premium is $0.10 per share, you make that full premium if the buyer holds the option until expiration and it is not exercised. You can buy back the option before expiration, but there is little reason to do so, and this isn't usually part of the strategy.
Risks and Rewards of the Covered Call Options Strategy
The risk of a covered call comes from holding the stock position, which could drop in price. Your maximum loss occurs if the stock goes to zero. Therefore, you would calculate your maximum loss per share as:
Maximum Loss Per Share = Stock Entry Price - 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 money from your option premium reduces your maximum loss from owning the stock. The option premium income 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, calculate your maximum profit as:
Maximum Profit = ( 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 underlying stock's price will need to fall below the call's 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 Thoughts 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 you already own. Assuming the stock doesn't move above the strike price, you collect the premium and maintain your stock position (which can still profit up to the strike price).
Traders should factor in commissions when trading covered calls. If commissions erase a significant portion of the premium received—depending on your criteria—then it isn't worthwhile to sell the option(s) or create a covered call.