What Is a Covered Call?
A covered call is an options trading strategy where an investor sells a call option on an underlying asset they already own. This strategy belongs to the broader category of options trading and is often employed by investors seeking to generate income generation from their existing stock holdings, particularly in neutral or moderately bullish market environments. By writing a covered call, the investor receives an upfront payment, known as the option premium, in exchange for giving the option buyer the right to purchase the shares at a predetermined strike price before a specific expiration date.
History and Origin
The concept of options, while formalized in modern finance, has roots dating back to ancient times, with early forms of contracts resembling options used to manage risk in commodity markets, such as Aristotle's account of Thales of Miletus and his dealings in olive presses. Modern, standardized options trading, however, began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This marked a significant shift from informal over-the-counter agreements to a regulated, centralized exchange, bringing transparency and liquidity to the market.6 The standardization of contracts paved the way for more sophisticated strategies like the covered call to become accessible to a wider range of investors.5
Key Takeaways
- A covered call involves selling a call option against shares of stock already owned.
- The primary goal is to generate income through the collection of the option premium.
- The strategy caps potential upside gains on the underlying stock above the strike price.
- It provides limited downside protection, only to the extent of the premium received.
- Covered calls are generally considered a more conservative options strategy compared to selling uncovered or "naked" options.
Formula and Calculation
The profit or loss for a covered call strategy can be calculated at the option's expiration based on the stock price relative to the strike price and the initial premium received.
The maximum profit from a covered call is:
This maximum profit occurs if the stock price at expiration is at or above the strike price, leading to the shares being "called away" (assigned).
The break-even point for a covered call is:
If the stock price falls below this break-even point, the strategy will incur a loss.
Interpreting the Covered Call
A covered call is interpreted primarily as an income-generating strategy rather than a growth-oriented one. When an investor implements a covered call, they are essentially expressing a belief that the underlying asset will either remain relatively stable or experience only a modest increase in price over the option's life. The premium collected offers a small buffer against a decline in the stock's price, serving as a form of partial hedging. However, if the stock's price significantly exceeds the strike price by the expiration date, the investor's upside potential is limited to the strike price plus the premium. This means they forgo any further capital gains beyond that point.
Hypothetical Example
Consider an investor, Sarah, who owns 100 shares of Company XYZ, purchased at $50 per share. She decides to write a covered call to generate income.
- Current Situation: Sarah holds 100 shares of XYZ at $50/share (Total Value: $5,000).
- Selling the Call: Sarah sells one XYZ call option contract (representing 100 shares) with a strike price of $55 and an expiration date one month out. She receives an option premium of $1.50 per share, or $150 ($1.50 x 100 shares).
- Scenario 1: Stock Price Stays Below Strike Price: If, at expiration, XYZ's stock price is $53, the call option expires worthless. Sarah keeps the $150 premium, and she still owns her 100 shares of XYZ, which are now worth $5,300. Her total return is ($5,300 - $5,000) + $150 = $450.
- Scenario 2: Stock Price Rises Above Strike Price: If, at expiration, XYZ's stock price is $57, the call option is "in-the-money," and Sarah's shares are "called away." She is obligated to sell her 100 shares at the $55 strike price. Her total proceeds are ($55 x 100 shares) + $150 premium = $5,650. Her total profit is $5,650 (proceeds) - $5,000 (initial cost) = $650. However, she missed out on additional gains beyond $55 if she had simply held the stock, as the stock is now trading at $57.
Practical Applications
Covered calls are a versatile tool in portfolio diversification and can be used by investors for several practical purposes. Primarily, they are employed for income generation, providing a regular cash flow from existing stock holdings. This can be particularly appealing for investors who hold long-term positions and want to extract additional value without selling their shares outright. The strategy also offers a limited degree of risk management by partially offsetting potential losses in the underlying stock, as the premium received acts as a buffer.
Furthermore, covered calls can be used as part of an exit strategy for a stock position, allowing an investor to pre-set a selling price for their shares while also earning income. The U.S. Securities and Exchange Commission (SEC) provides guidance and regulations concerning options trading, including strategies like the covered call, to ensure investor protection and market integrity.4
Limitations and Criticisms
Despite their popularity for income generation, covered calls come with notable limitations and criticisms. The most significant drawback is the capping of upside potential. By selling a call option, the investor forfeits any capital gains beyond the strike price, even if the underlying asset rallies significantly. This means that while the strategy can perform well in flat or slightly bullish markets, it will underperform a simple buy-and-hold strategy in strongly rising markets.3
Another criticism is that the premium received offers only limited downside protection. If the stock experiences a substantial decline, the small option premium will not be enough to offset the losses from the depreciating stock. Consequently, the covered call writer still bears the full risk of a significant fall in the stock's price, minus the premium collected.2 Additionally, active management may be required, especially in volatile markets, to adjust positions or roll options, which can incur additional transaction costs and potentially reduce overall profitability. Academic research has explored the risk-return characteristics, noting that while covered calls can improve the risk-return trade-off in certain scenarios, they are not a panacea for all market conditions.1
Covered Call vs. Naked Call
A covered call and a naked call are both options trading strategies involving the selling of a call option, but their risk profiles and capital requirements differ dramatically.
In a covered call, the seller already owns the underlying asset (e.g., 100 shares of stock) against which the call option is sold. This ownership "covers" the obligation to deliver the shares if the option is exercised, limiting the potential loss from an upward movement in the stock price to the difference between the stock's purchase price and the strike price, plus the premium received. The primary risk is the loss of unrealized gains above the strike price and potential losses on the stock if it declines.
Conversely, a naked call (also known as an "uncovered call") involves selling a call option without owning the underlying asset. This exposes the seller to theoretically unlimited risk. If the stock price rises significantly, the seller must purchase the shares in the open market at a higher price to fulfill the obligation, potentially incurring substantial losses. Due to this extreme risk, naked calls typically require higher margin requirements and are generally only suitable for experienced traders with a high risk tolerance.
FAQs
Can you lose money with a covered call?
Yes, you can lose money with a covered call. While the strategy offers some income generation from the option premium, it does not protect against a significant decline in the underlying asset. If the stock price falls below your original purchase price minus the premium received, you will incur a net loss on the position.
What happens if the stock price goes above the strike price?
If the stock price goes above the strike price by the expiration date, your shares will likely be "called away," meaning you are obligated to sell them to the option buyer at the strike price. Your profit is capped at the difference between the strike price and your original purchase price, plus the premium received. You will miss out on any further upside beyond the strike price.
Is a covered call a good strategy for beginners?
A covered call is often considered one of the more conservative options trading strategies, making it potentially suitable for beginners who already own shares and wish to generate additional income. However, understanding the mechanics of stock options, including the concepts of strike price, expiration date, and the trade-off between income and capped upside, is essential before engaging in this strategy.
How often should you write covered calls?
The frequency of writing covered calls depends on market conditions, your investment goals, and the volatility of the underlying stock. Some investors write calls monthly or quarterly, aligning with typical option expiration cycles, to consistently collect premiums. Others may choose to write them less frequently, or only when they believe the stock is likely to remain range-bound or experience moderate appreciation.