Covered Call

Updated on April 9, 2024
Article byAswathi Jayachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Covered Call?

A covered call is a strategy employed by investors in a range-bound market. It helps them profit from a stock’s holdings by using its potential upside in the derivatives market. Investors who execute covered calls own the same amount of underlying stock as the call options.

Traders create a covered call by taking a long position in a security and a short position in its call option. In exchange for an option premium, the combined position restricts the investor’s ability to profit from the underlying security’s increase in value. One can use it to generate a regular source of income.

Features of Covered call

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Key Takeaways

  • A covered call strategy is an options trading strategy employed by investors in range-bound markets. It is done by holding long positions in securities and short positions in its call option’s underlying indices.
  • The combined position limits the investor’s potential to gain from the rise in the value of the underlying security in exchange for an option premium.
  • It has the potential to make decent profits. However, investors cannot discount the risk of losses.
  • Investors must pay a margin if they choose to write an option.

Covered Call Option Strategy Explained

A covered call is an options strategy and a risk management tool. Long stock and short volatility exposure are provided through these calls. It applies when an investor has an optimistic outlook for the medium to long term. Still, the market looks mildly bullish for the short term and, however, still wants to make additional money during this period. An investor’s potential profit is in constraints here, and similarly, the amount of protection provided in the event of stock price declination is also modest.

In simple words, the covered call option strategy is an example of a technique in options in which a trader combines owning the underlying asset with an options contract on the underlying security. This approach aims to generate profits in the form of premiums (by writing a call option) while the traders maintain a long position in a security. Investors exercise the call when they foresee a bullish market. The investor chooses the selling covered calls option as they are aware that they cannot make big gains simply by hanging onto the underlying assets.

Premiums generate profits until that strike price is reached and sold at that strike price. A trader can only make a certain amount of money as gains, but the potential losses these executions can incur are high. As a result, investors and traders shall utilize these after careful consideration when the market is less volatile. Poor man’s covered call can be an alternative for investors looking for a cheaper, capital-efficient alternative.

Covered Call Payoff

Let us develop a comprehensive understanding of the covered call payoff concept with the help of the graph and explanation provided below:

Suppose David purchases Stock A at $200 and sells a call option at a strike price of $210 for $5. A reduction in the cost of the original position takes place by $10. Hence, the long stock position’s break-even point and cost basis is $190.

In case the stock price falls lower than that price, the associated downside risk will not have any limit until the price of the security gets to $0, less the adjusted cost basis. Note that if the call option is in the money or ITM, the profit potential will be restricted to the sum of the strike price of the option plus the overall premium accumulated from selling that option. 

The option seller will have an obligation to sell Stock A shares at an amount equivalent to the short strike price when assigned. This will result in the long stock position’s closing.

At the time of expiration, if Stock A closes over the $210 mark, the realization of $2,000 profit per contract will take place as the stock gained $10 per share ($1,000), plus the credit David received through the covered call option’s sale (1,000). In case the stock closes under the short call at the time of expiry, the option will be subject to a worthless expiration while the credit received by David will stay. 

One must remember that offloading a covered call restricts the profit potential. That said, it cannot get rid of the downside risk.

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Example #1

Dan wants to purchase 1,000 shares of an “amazing” company and does so at the cost of $100 per share. Seeing the past few months’ stock market performance, Dan concludes that the market will not experience significant volatility. Therefore, he estimates a growth per stock price of $150 in 6 months. He thinks about selling covered calls for 100 shares for $150 in the next six months and decides to do it. He adds the premium price of $5 per share in the contract. The stock price, however, increased to $155 after six months. Therefore, the profit incurred is $5 per share. However, since the call option was not for $155 but $150, Dan will receive 150*100+$5 per share (from the call premium). The total amount received would be $15,500. 

Example #2

Another investor, Dave, invests in the company “brilliance Inc.” He buys 1,000 shares at $100 each, expects the market to be stable, and predicts $150 per share in six months at a premium of $5 per share. However, the stock market crashed, and share prices fell to $80. As a result, stock losses total $20 per share (100-80). However, the premium of $5 per share is available, and the losses are partially offset against it. Here, the loss will be $20–$5 per share, which equals $15 per share. Therefore the losses are minimized through the covered call option strategy.

Writing a Covered Call

If an investor chooses to write an option, they must pay a margin. However, if an investor owns a stock and wishes to sell an option or write for that stock, there is no need to pay any additional amounts as margin. By writing a covered call, traders and investors essentially sell the right for someone else to buy their shares within a set time frame and at a given price. Therefore, they can generate additional revenue on the current corpus by writing these calls.

Writing a good call option involves deciding the stocks, especially those that seem bullish in the long run. First, investors shall determine the price according to the investor’s risk-to-reward considerations. This is called the “strike price.” The next step would be to choose an expiry date. It will be one that can give a significant amount of premium to make a sale at the strike price. These steps complete the process.

Covered Call Risks

When writing a call option, circumstances may arise when the stock may rise significantly above the strike price. In such scenarios, it might restrict the amount of profit made (as it is above the anticipated price level). Therefore, it can be particularly good for stocks that trade within particular ranges.

A covered call is effective in a rising market since stocks often increase in value over time. However, investors shall avoid them if the market is in the correction phase. This is because the premium collected might not be enough to offset the loss incurred due to the stock’s value declinePoor man’s covered call can be an alternative to avoid major losses.

Frequently Asked Questions (FAQs)

How does covered call work?

A call option is made with an expiry date. A “strike price” is also decided, an amount higher than the buy price. The value chosen must generate a significant profit. Investors reap profit when the cost of the stock goes above the strike price.

What is a covered call ETF?

Covered call ETF refers to call options on a portion of the underlying shares sold (or “written”) by ETFs. Since the ETF (exchange-traded fund) owns the equities underlying the contracts, they are referred to as “covered call ETFs.”

What happens when a covered call expires in the money?

When the strike price gets executed on the decided expiry date, the investor either gains a profit (if it closes above the strike price) or a loss (if it closes below the buy price). On the other hand, if the stock price remains unchanged, the investor will not receive any returns.

How to close a covered call?

It is automatically executed on expiry. Therefore, closing calls before expiry is not recommended. It is best to only do this when there is a risk that the stock value will fall. Alternatively, if the investors determine there are better uses for the money.

This has been a guide to covered call and its definition. We explain the writing of the covered call, strategy, examples, and risks associated with it. You may learn more from the following articles –

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