Covered calls

Covered Calls: Definition, Formula, Example, and FAQs

What Is Covered Calls?

A covered call is an options strategy where an investor holding a long position in an underlying asset, typically shares of a stock, sells a call option on that same asset. This approach is primarily used for income generation by collecting the premium from selling the options contract. The strategy is "covered" because the seller already owns the shares, which stand as collateral to fulfill the obligation if the option is exercised.

History and Origin

While the formal, standardized trading of options is a relatively modern development, the conceptual roots of agreements resembling options date back to ancient times. The Greek philosopher Thales of Miletus is often cited for a historical example involving the control of olive presses, illustrating an early form of a contingent contract. Over centuries, various forms of options were traded in over-the-counter markets. The modern era of options trading began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This marked the first time that options contracts were standardized, creating a regulated and liquid marketplace. Simultaneously, the Options Clearing Corporation (OCC) was founded to provide centralized clearing and guarantee contract fulfillment, which significantly bolstered investor confidence and legitimacy in the burgeoning options market.⁸

Key Takeaways

• A covered call involves owning shares of stock and selling a corresponding number of call options.
• The primary goal of a covered call strategy is to generate additional income from the collected option premium.
• This strategy limits potential upside profit in exchange for the premium income.
• Covered calls offer a limited degree of downside protection, as the premium received acts as a buffer against a decline in the underlying stock's price.
• The strategy is generally considered conservative compared to other options strategies due to the "covered" nature of the position.

Formula and Calculation

The maximum profit for a covered call strategy is calculated as the sum of the initial stock purchase price and the premium received, minus the strike price at which the call option is sold.

The maximum profit (Max Profit) from a covered call is given by:

The break-even point for a covered call is the initial stock purchase price minus the premium received:

Variables:

• Stock Purchase Price: The price paid per share for the underlying stock.
• Strike Price: The price at which the buyer of the call option can purchase the underlying stock.
• Premium Received: The amount received per share for selling the call option.

Interpreting the Covered Call

A covered call is typically implemented by investors who hold a neutral to moderately bullish outlook on an underlying asset. By selling a call option, the investor agrees to sell their shares at a predetermined strike price if the option is exercised before its expiration date. In exchange for this obligation, they receive a premium upfront.

The interpretation revolves around a trade-off: the investor caps their potential capital appreciation if the stock price rises significantly above the strike price. However, they gain immediate income generation from the premium, which can offset minor price declines in the stock or enhance returns in a flat market. This strategy transforms potential upside beyond the strike price into upfront income, providing a small buffer against downside movements.

Hypothetical Example

Consider an investor who owns 100 shares of XYZ Corp., currently trading at $50 per share. The investor believes XYZ stock might not rise significantly in the short term but wishes to generate extra income.

1. Action: The investor sells one covered call options contract for XYZ Corp. with a strike price of $55 and an expiration date one month away, receiving a premium of $1.50 per share (or $150 for the 100-share contract).
2. Scenario A: Stock rises above strike price. If, at expiration, XYZ Corp. trades at $58 per share, the call option buyer will likely exercise their right to purchase the shares at the $55 strike price. The investor sells their 100 shares at $55 each, making a $5 profit per share from the stock's appreciation ($55 strike - $50 purchase price) plus the $1.50 premium per share. Total profit: $500 (from stock) + $150 (premium) = $650. The investor misses out on the additional $3 per share upside beyond the $55 strike price (i.e., $58 market price - $55 strike price).
3. Scenario B: Stock stays below strike price. If, at expiration, XYZ Corp. trades at $52 per share, the call option will expire worthless as the market price is below the $55 strike price. The investor retains their 100 shares of equity and keeps the $150 premium. Their total return from the strategy would be the $150 premium, partially offsetting any potential unrealized loss from the stock's slight decline from $50 to $52.

Practical Applications

Covered calls are a widely used strategy in investment management for several key purposes:

• Income Enhancement: They are commonly employed to generate regular income from a stock portfolio, particularly for investors seeking to supplement existing dividend income or boost returns in stagnant or moderately rising markets. Many exchange-traded funds (ETFs) utilize covered call strategies to provide consistent yield to investors.⁷
• Targeted Selling: An investor who intends to sell a stock at a specific price can use a covered call to potentially achieve that sale price while collecting a premium in the interim.
• Risk Mitigation: While not offering extensive downside protection, the premium received from selling a covered call acts as a small cushion against potential losses if the underlying stock experiences a modest decline. This can be part of a broader risk management approach.
• Portfolio Management: Portfolio managers may use covered calls on portions of their holdings to lower the effective cost basis of shares or to smooth out portfolio returns by reducing exposure to extreme upward volatility. Central banks and other large financial institutions monitor options contracts and market activity as indicators of overall market sentiment and liquidity.⁶

Limitations and Criticisms

Despite their popularity, covered calls come with significant limitations and are not without criticism. The most prominent drawback is the limited upside potential. If the underlying asset's price rises sharply above the strike price of the sold call option, the investor is obligated to sell their shares at that strike, thereby foregoing any further capital appreciation. This can lead to underperformance relative to a simple buy-and-hold strategy in strong bull markets.⁵

Furthermore, while the collected premium offers some buffer, it provides only limited protection against substantial declines in the underlying asset's price. In a severe bear market, the premium might only slightly offset significant losses in the stock. Academic research on covered calls suggests that while they can reduce volatility, they may not consistently outperform a buy-and-hold strategy in terms of total returns over long periods, especially in strong upward trending markets.⁴,³,² Investors should be aware that all investment products, including options, carry risks, and it is possible to lose the entire initial investment.¹

Covered Calls vs. Naked Calls

The primary distinction between covered calls and naked calls lies in the ownership of the underlying asset.

A covered call is a relatively conservative options strategy where the risk of the sold call is "covered" by the owned shares. Conversely, a naked call involves selling a call option without owning the underlying stock. This exposes the seller to potentially unlimited losses if the stock price rises significantly, as they would have to buy the shares at a higher market price to fulfill their obligation.

FAQs

What happens if the stock price goes above the strike price?

If the stock price of the underlying asset rises above the strike price by the expiration date, the call option is "in-the-money." This means the buyer of the option will likely exercise their right to purchase the shares from you at the strike price. You would be obligated to sell your shares, realizing a profit up to the strike price plus the premium collected, but foregoing any gains beyond the strike price.

Can covered calls be rolled forward?

Yes, a common adjustment strategy for covered calls is "rolling" the position. This involves buying back the existing, expiring, or in-the-money options contract and simultaneously selling a new covered call with a later expiration date and/or a different strike price. This can be done to extend the income stream, avoid early assignment, or adjust the risk management profile.

Are covered calls suitable for all market conditions?

Covered calls tend to perform best in flat or moderately rising markets, or even slightly declining markets where the stock price remains above the break-even point. They are generally less effective in sharply rising bull markets, where they cap upside gains, or in steeply falling bear markets, where the premium income may be insufficient to offset significant losses in the underlying asset.