A covered call is an options trading strategy where an investor sells call options on a stock they already own. This approach allows investors to generate additional income from their stock holdings by collecting premiums from the sale of call options. Professional investors frequently use covered calls to enhance investment returns, but individual investors can also benefit from this conservative yet effective strategy by understanding its mechanics and knowing when to deploy it.
Key InsightsKey Takeaways
- Generate Income: Covered calls are used to generate income when investors believe stock prices will remain stable or rise slightly.
- Long Position and Call Selling: The strategy involves holding a long position in a stock and then selling call options on the same stock.
- Limited Upside, Some Protection: While covered calls limit the potential upside profit, they provide some protection against minor declines in stock prices.
How a Covered Call Works
As a stockholder, you have several rights, including the right to sell your shares at the current market price. When you write a covered call, you sell this right to another investor in exchange for a cash premium. The buyer of the call option acquires the right to purchase your stock at a predetermined price, known as the strike price, on or before the option's expiration date.
A call option gives the buyer the right, but not the obligation, to buy shares of the underlying stock at the strike price at any time before the option expires. If you own the underlying stock, the option is considered "covered" because you can deliver the shares without purchasing them on the open market at potentially unfavorable prices. Selling a call option without owning the underlying stock is known as a "naked call," which carries higher risk because you might need to buy the stock at a higher price if the option is exercised.
Profiting From Covered Calls
When you sell a call option, you receive a premium from the buyer. This premium is yours to keep regardless of whether the option is exercised. A covered call is most profitable if the stock price remains below the strike price until the option expires, allowing you to retain the premium without having to sell your shares.
If the stock price rises above the strike price and the buyer exercises the option, you must sell your shares at the strike price. While this limits your profit potential, you still benefit from the premium received plus any gains up to the strike price.
When to Sell a Covered Call
Selling a covered call can be beneficial when you expect the stock to remain relatively stable or increase slightly. For example, if you purchase a stock at $80 per share and anticipate it might rise to $90 within a year but are willing to sell at $85 within six months, writing a covered call could be an appropriate strategy.
Assume the stock's option chain indicates that selling an $85 six-month call option earns a $5 per share premium. By selling that option, you agree to sell your shares at $85 if the stock price reaches that level. In this situation, you keep the $5 premium, and if the stock is called away, you sell at $85, resulting in a total income of $90 per share ($85 from the sale plus the $5 premium). This represents a 12.5% return over six months.
If the stock price drops to $70, the option will not be exercised, and you will incur a $10 loss on the stock. However, the $5 premium received reduces the loss to $5 per share.
Example Scenarios
Bullish Scenario: Shares Rise to $110 and the Option Is Exercised
- January 1: Buy ABC shares at $90
- January 1: Sell ABC call option for $6, expires June 30, exercisable at $100
- June 30: Stock closes at $110, option is exercised, you sell shares at $100
- July 1: Profit: $10 capital gain + $6 premium = $16 per share (17.8%)
Bearish Scenario: Shares Drop to $75 and the Option Is Not Exercised
- January 1: Buy ABC shares at $90
- January 1: Sell ABC call option for $6, expires June 30, exercisable at $100
- June 30: Stock closes at $75, option expires worthless
- July 1: Loss: $15 share loss - $6 premium = $9 per share (10% loss)
Advantages of Covered Calls
Covered calls enhance portfolio yield by generating income from premiums, supplementing dividends, and potentially increasing overall returns. They are particularly effective in stagnant or slightly bearish markets where significant stock appreciation is unlikely. Additionally, covered calls provide some downside protection. By receiving the premium from selling the call option, investors effectively lower their cost basis in the stock, cushioning against minor price declines.
Risks of Covered Calls
Covered calls require holding the underlying shares or contracts to avoid the risks of naked calls, which have theoretically unlimited loss potential if the stock price rises significantly. This necessitates buying back options positions before expiration if you wish to sell the shares, which increases transaction costs and may reduce net gains or amplify losses.
Another risk is potential loss if the stock price declines significantly. While the premium provides some protection, it may not fully offset the losses if the stock drops below the breakeven point (original purchase price minus the premium).
Directional Covered Call Without the Stock
An alternative to the standard covered call is the directional covered call strategy, which involves purchasing a longer-dated call option instead of buying the stock, and selling a shorter-dated call option. This strategy reduces capital requirements and offers potentially higher percentage returns with limited risk.
Example:
Standard Covered Call:
- Buy 100 shares at $120
- Sell one December 115 call at $12
- Cost: $12,000 - $1,200 = $10,800
- Max profit: $700 (6.5%)
Directional Covered Call Without the Stock:
- Buy three January 110 calls at $8
- Sell two December 115 calls at $12
- Cost: $2,400
- Max profit: $2,000 (83.3%)
The Traditional Covered Call
Typically, investors use the traditional covered call strategy to hedge their stock positions or generate income. For example, suppose an investor buys 100 shares of a stock at $80 per share and sells a call option with a strike price of $80, collecting a $4 premium. The total investment is $8,000, minus the $400 premium, making the breakeven price $76 per share.
If the stock drops to $76, the investor loses $400 on the stock but retains the $400 premium, breaking even. If the stock price exceeds $80 at expiration, the stock may be "called away," capping the profit at $400. The covered call thus has limited upside and reduced, but not eliminated, downside risk.
To mitigate the risk of their stock being called away, investors often sell out-of-the-money options, which also reduces the capital required for the trade and potentially increases the rate of return. However, the capital needed to purchase the stock can still be substantial, and the return on investment can be relatively low. Therefore, an alternative strategy can offer better returns without the high cost and unfavorable risk-reward profile of traditional covered calls.
Trade the Covered Call—Without Owning the Stock
In this variation, rather than purchasing 100 shares of stock, the investor opts for a longer-dated, lower strike price call option to replace the stock and sells more options than they buy. This strategy, called a calendar spread, offers:
- Lower initial investment
- Potential for higher returns
- Limited risk with profit potential
An Example
Let's take a stock trading at $60.50, with a March 60 call option priced at $7.50. The traditional buy/write strategy involves:
- Buying 100 shares of stock at $60.50
- Selling one March 60 call at $7.50
The investor spends $6,050 for the stock and receives $750 from the option premium, resulting in a breakeven price of $53 ($60.50 - $7.50). The maximum profit potential is $700 ([$60 + $7.50 - $60.50] x 100). This translates to investing $5,300 for a potential $700 profit, or a 13.2% return.
Now, let's consider an alternative using only options:
- Buy three June 55 calls at $9.20 each
- Sell two March 60 calls at $7.50 each
Entering this trade costs $1,930 (300 x $9.20 - 200 x $7.50), roughly half the amount needed for the traditional trade.
Example Results
Suppose the stock rises to $75 by March expiration. The traditional investor would have their stock called away at $60, earning $700 on a $5,300 investment, or 13.2%.
The alternative strategy's investor could sell their three June 55 calls at $25 each and buy back the two March 60 calls at $20 each, yielding a profit of $2,400 on a $1,930 investment, or 124.4%.
In Conclusion
Covered calls are an effective strategy to generate income and reduce the cost basis of stock holdings. However, they come with risks, including limited profit potential and potential losses if the stock price declines significantly. Understanding when and how to use covered calls can help investors enhance returns and manage portfolio risks effectively.