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A covered call is an option trading strategy that offers limited returns at limited risk. A covered call involves selling a call option on a share you already own. By owning the stock, you are ‘covered’ (i.e. protected) if the stock rises and the call option expires ‘in the money’. A covered call is one of the lower risk option strategies and is suitable even for novice options traders. You can use a covered call for options trading with any of the best brokers.
Here’s how a covered call works, what the pros and cons are, and when to use this options strategy.
What is a covered call option strategy?
A covered call is a basic options strategy where you sell (or “go short” as the pros call it) a call option for every 100 shares of the underlying stock you own. It’s a relatively simple options trade to set up, and it generates some income from a stock position.
A covered call is a type of hedged strategy in which the trader sells a portion of the stock’s price gain over a set period of time in exchange for the option premium. Normally, selling a call option is risky because it exposes the seller to unlimited losses if the stock rises. However, by owning the underlying shares you limit those potential losses and can generate income.
When the call option expires, one of two things will happen:
- If the stock finishes above the call’s strike price, the price at which the call goes into the money, the call buyer will buy the stock from you at the strike price. The call seller retains the option premium.
- If the stock finishes below the call’s strike price, the call seller keeps both the stock and the option premium. The call buyer’s option expires worthless.
Let’s look at an example to see how it all works.
ABC stock trades at $20 per share, and a call with a strike price of $20 expiring in three months costs $1. The contract costs a premium of $100, or $1 * 1 contract * 100 shares per contract. To execute a covered call, the investor buys 100 shares of ABC for $2,000 and then sells one call to receive $100.
Here are the profits and losses on the different elements of the covered call:
In this example, the trader who set the covered call breaks even on the entire trade at $19 per share. That is the share price of €20 minus the premium received of €1. At stock prices below this, the trader loses money, which more than offsets the $1 premium received. If the stock price is less than $20 at expiration, the trader keeps the stock and retains the entire premium.
At a stock price of $20 at expiration, the trader retains the full $1 premium and the stock is typically not called by the call buyer. So the trader makes $100 at this stock price.
For stock prices above $20 at expiration, the trader’s profit is capped at $100. While the short call loses $100 for every $1 increase in the stock price above $20, that loss is fully offset by the stock’s gain. As a result, the trader gets a profit of up to $100, the original premium received. In this situation, the trader loses all potential stock gains above $20 per share.
In reality, if the stock rises too high above the strike price, the trader has lost money – money that would otherwise have been made. But by holding 100 shares for each contract sold, the trader hedges the risk and can still enjoy some upside.
For all covered calls, the maximum benefit is the option premium, regardless of where the stock goes. While you can’t earn more, you can certainly lose more. The stock could fall – potentially to $0 – and the premium will be the only upside. In this example, you earn $100 on the option premium, but lose $2,000 on the stock, resulting in a net loss of $1,900.
Of course, if the stock has fallen sharply, you can buy back the call option for less than you paid and then sell the stock position, if you wish.
Advantages and disadvantages of covered calls
A covered call can be an attractive options strategy for several reasons, but, like all options strategies, it also has its disadvantages.
Benefits of a covered call
- Generates income from a position. A covered call can generate income from a stock position that may or may not pay a dividend, increasing its overall profitability.
- Relatively low risk. A covered call is a way to trade options with relatively little risk, because you protect the short call with your stock position.
- Easy to set up. A covered call is also a relatively easy position to establish. It is important to buy the shares first and only then sell the call.
- Covers your risk. A covered call hedges your risk in a position by providing some compensation.
- Can be reset again and again. If the call expires worthless and you keep your shares, you can always reset the covered call. Even if your shares are called by you, you can buy back the shares and set a covered call again.
Disadvantages of a covered call
- Small, limited advantage in exchange for disadvantage. With a covered call you can earn a relatively small income, but you have to bear any downsides of the stock, which can lead to a potentially skewed risk-reward ratio.
- Trading all the positive sides of the shares. One of the reasons you probably own the stock is because its potential can increase over time. By setting a covered call, you trade with this advantage until the option’s expiration date. If the stock rises, you lose any profit you could have earned.
- Can “lock” your shares until the option expiration date. If you sell a call option, you may not feel inclined to sell your shares until the option expires, although you can buy back the call option and then sell the shares.
- Requires more capital to set up. With a covered call, you need money to buy shares, and that requires significantly more cash than a pure options strategy.
- Can create taxable income. Selling a successful covered call generates taxable income in a taxable account. If the underlying shares are withdrawn from you, this could also lead to a further tax liability if you had a capital gain on the shares.
Best times to use covered calls
A covered call can make sense in a number of scenarios, including the following:
- You don’t expect the stock to move much. With a covered call, a trader does not want the stock price to rise above the option’s strike price, at least until after the option expires. And it’s also good if the shares don’t fall much. If the stock stays mostly flat, you can still collect your premium and not lose much, if any, profit.
- You want to generate revenue from a feature. If you want to take advantage of the relatively high price of option premiums, you can place a covered call and generate income. In effect, it’s like creating a dividend from stocks.
- You trade in a tax-advantaged account. If you use covered calls, you will generate income and potentially get the stock called away, both of which can result in tax liabilities. So setting up covered calls within a tax-advantaged account like an IRA can be attractive, allowing you to avoid or defer taxes on these gains.
When should you avoid a covered call?
A covered call should probably be avoided in the following situations:
- You expect the stock to rise in the near future. There is little point in selling a stock’s potential upside in exchange for a relatively small amount of money. If you think a stock is about to go higher, you should probably hold it and let it rise. After it has climbed quite a bit, consider setting up a covered call.
- The stock has a serious downside. When you hold a stock, you generally expect it to rise. But don’t use a covered call to try to get extra money from a stock that is going to drop significantly in the short or long term. It’s probably best to sell the stock and move on, or you can try selling the stock short and profiting from its decline.
In short
A covered call can be a way to use options to generate income with relatively little risk, and is often popular with older investors who don’t want to sell their positions but would like some income. With a covered call you earn a limited return in exchange for running an often limited risk.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
