Option strategy

What Is a Covered Call?

A covered call is an option strategy where an investor holds a long position in an asset, typically 100 shares of a stock, and simultaneously sells (writes) a call option on the same asset. The "covered" aspect refers to owning the underlying asset, which provides protection against the potentially unlimited losses that could arise from selling a call option without owning the underlying. This strategy is often employed by investors seeking to generate income generation from their existing holdings, while subtly limiting their upside potential.

History and Origin

Prior to the formalization of options trading, these financial instruments were often bilateral, over-the-counter agreements with complex terms. The modern era of standardized options trading began with the founding of the Chicago Board Options Exchange (CBOE) in 1973. The CBOE introduced standardized contract terms, centralized liquidity, and a dedicated clearing entity, making options accessible to a broader range of investors. This standardization paved the way for more sophisticated strategies, including the covered call, to become widely practiced. The CBOE was instrumental in transforming options from a niche, manual market to an electronic, automated industry.¹⁴

Key Takeaways

• A covered call involves owning 100 shares of a stock and selling one call option against those shares.
• The primary goal is to generate premium income, enhancing returns on a stagnant or moderately rising stock.
• It limits the investor's upside potential if the stock price rises significantly above the strike price of the sold call.
• The strategy provides a degree of hedging against a small decline in the stock's price, as the collected premium absorbs some losses.
• The risk of the covered call strategy is that the underlying stock may decline significantly, leading to losses on the stock position that outweigh the premium received.

Formula and Calculation

The profit or loss for a covered call strategy at expiration date can be calculated based on the stock price at expiration relative to the initial purchase price of the stock and the premium received from selling the call option.

The maximum profit for a covered call is realized if the stock price at expiration is at or above the strike price of the sold call option. The maximum profit formula is:

The breakeven point for a covered call is the stock purchase price minus the premium received:

The maximum loss occurs if the stock price falls to zero, in which case the loss is limited to the stock purchase price minus the premium received:

These calculations illustrate the balance between the income generated from the option premium and the price movement of the underlying shares.

Interpreting the Covered Call

A covered call strategy reflects a moderately bullish or neutral outlook on the underlying asset. By selling a call option, the investor expresses the belief that the stock price will either remain relatively stable, decline slightly, or rise but not significantly beyond the call option's strike price before expiration.

If the stock price stays below the strike price at expiration, the call option expires worthless, and the investor retains the premium and the stock. This is the ideal scenario for income generation. If the stock price rises above the strike price, the call option will likely be exercised, meaning the investor must sell their shares at the strike price. In this case, the investor forfeits any potential gains beyond the strike price, but still profits from the difference between the stock purchase price and the strike price, plus the premium. Conversely, if the stock price falls, the investor still owns the shares and has the premium to offset some of the loss. The strategy reduces the overall risk slightly compared to simply holding the stock, but also caps potential upside.

Hypothetical Example

Consider an investor, Sarah, who owns 100 shares of Company XYZ, which she purchased at $50 per share. The total cost of her stock position is $5,000. Sarah believes Company XYZ's stock might trade sideways or experience a modest increase in the short term. To generate additional income, she decides to implement a covered call strategy.

1. Sell Call Option: Sarah sells one call option contract (representing 100 shares) on Company XYZ with a strike price of $55 and an expiration date one month away. She receives a premium of $1.50 per share, or $150 for the contract.
2. Scenario 1: Stock Price below Strike at Expiration: If, at expiration, Company XYZ's stock is trading at $52, the call option expires worthless. Sarah keeps the $150 premium, and her 100 shares of XYZ are still worth $5,200. Her total return from the strategy is the $200 increase in stock value ($5,200 - $5,000) plus the $150 premium, totaling $350.
3. Scenario 2: Stock Price above Strike at Expiration: If, at expiration, Company XYZ's stock is trading at $58, the call option will be exercised. Sarah is obligated to sell her 100 shares at the $55 strike price. She sells her shares for $5,500. Her initial stock cost was $5,000. She also keeps the $150 premium. Her total profit is ($5,500 - $5,000) + $150 = $650. However, she missed out on the additional $3 per share (from $55 to $58) had she simply held the stock.
4. Scenario 3: Stock Price declines: If, at expiration, Company XYZ's stock is trading at $48, the call option expires worthless. Sarah keeps the $150 premium. Her shares are now worth $4,800. Her total loss from the stock's decline is $200 ($5,000 - $4,800), which is partially offset by the $150 premium, resulting in a net loss of $50. This demonstrates how the premium provides a limited buffer against a downward movement.

Practical Applications

The covered call strategy is widely used by investors seeking to enhance returns from a portfolio of stocks, particularly in markets experiencing low volatility or moving sideways. It is a common strategy for individuals and institutional investors who employ a buy and hold approach but want to generate extra income from their holdings. For instance, pension funds or endowment managers with large stock positions might write covered calls to boost quarterly income. Academic research has explored the performance of covered call strategies, suggesting they can offer returns not far below those of the equity market but with significantly lower volatility.¹¹, ¹², ¹³ Covered call exchange-traded funds (ETFs) have also emerged, allowing investors to gain exposure to this strategy without directly managing individual option contracts.¹⁰ Furthermore, options pricing, derived from market activities including covered calls, contributes to broader economic insights, with institutions like the Federal Reserve utilizing option prices to gauge market-implied probabilities for various economic outcomes.⁸, ⁹

Limitations and Criticisms

While a covered call offers benefits, it comes with inherent limitations and potential criticisms. The most significant drawback is the capping of potential upside profit. If the underlying stock experiences a substantial price surge above the strike price, the investor is obligated to sell their shares at the strike price, missing out on further gains. This opportunity cost can be considerable in strongly bullish markets.⁷

Another limitation is that while the premium received offers a small buffer against losses, it does not provide substantial protection against a significant downturn in the stock's price. If the stock declines sharply, the investor still incurs losses on the stock position, potentially outweighing the collected premium.⁶ The strategy also introduces additional complexity and transaction costs compared to simply holding shares.⁵ Investors should be aware of the "Characteristics and Risks of Standardized Options" document, which outlines various considerations for options trading, including those related to covered calls.⁴ Despite its popularity, some academic perspectives argue that, from a theoretical standpoint, a covered call strategy should not consistently outperform a simple buy-and-hold strategy on a risk-adjusted basis in efficient markets.², ³

Covered Call vs. Naked Call

The distinction between a covered call and a naked call is crucial for understanding the risk profiles associated with each strategy.

A covered call is considered a conservative option strategy because the investor owns the underlying shares, thereby "covering" the obligation to deliver the shares if the call is exercised. In contrast, a naked call involves selling a call option without owning the underlying shares. This exposes the seller to theoretically unlimited losses if the stock price rises significantly, as they would have to buy the shares at the higher market price to fulfill their obligation. Due to the vastly different risk exposures, regulatory bodies impose much higher margin requirements for naked call positions.¹

FAQs

Can a covered call lose money?

Yes, a covered call can lose money. While the premium received provides a small buffer, if the price of the underlying stock declines by an amount greater than the premium collected, the overall position will result in a loss. The maximum loss occurs if the stock price falls to zero.

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

If the stock price goes above the strike price of the call option at expiration, the option will likely be exercised. This means the investor will be obligated to sell their 100 shares of the stock at the strike price, even if the market price is higher. The investor keeps the premium received and profits from the increase in the stock's value up to the strike price.

Is a covered call a good strategy for beginners?

A covered call is often considered one of the more accessible option strategies for investors who already own stocks. It is less complex and has more defined risks than many other option strategies, such as the short straddle or iron condor. However, understanding options basics, including how premiums and expiration dates work, is essential before implementing this strategy.

How often should I write covered calls?

The frequency of writing covered calls depends on market conditions, the specific stock, and the investor's objectives. Some investors prefer to write monthly options to generate consistent income, while others may choose longer-dated options if they anticipate less volatility. Frequent trading can lead to higher transaction costs.

Does a covered call protect against all downside risk?

No, a covered call does not protect against all downside risk. The premium received from selling the call provides a limited amount of downside protection, effectively lowering the investor's breakeven point. However, if the stock price falls significantly below this adjusted breakeven point, the investor will incur losses on their stock position. The strategy reduces risk compared to just holding the stock, but it does not eliminate it entirely, nor does it compare to the comprehensive diversification benefits of a well-balanced portfolio.