What Is Selling Covered Calls?
Selling covered calls is an options trading strategy where an investor sells call option contracts against shares of an underlying asset they already own. This strategy is considered "covered" because the seller owns the equivalent amount of the underlying shares, which mitigates the risk of unlimited losses if the option is exercised. The primary goal of selling covered calls within the broader category of options trading is to generate additional premium income from existing stock holdings. It is often employed by investors who have a neutral to moderately bullish outlook on a particular stock, expecting its price to remain relatively stable or rise only slightly, rather than experiencing a significant surge.
History and Origin
The concept of options has existed for centuries, with early forms of contracts allowing for future transactions of goods. However, standardized, exchange-traded options, including the ability to engage in selling covered calls, began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. Prior to the CBOE, options were primarily traded over-the-counter with less transparency and standardization. The CBOE's innovation provided a regulated marketplace, standardized contract terms, and a central clearing entity (which became The Options Clearing Corporation, or OCC), making options trading more accessible and transparent for investors. This formalization paved the way for widespread adoption of strategies like selling covered calls, allowing investors to utilize them for income generation and risk management.6
Key Takeaways
- Selling covered calls involves holding a long position in a stock and selling call options against it.
- The primary benefit is collecting the option premium, which provides income or a partial hedge against a decline in the stock's price.
- The strategy limits the potential upside profit on the underlying stock, as shares may be "called away" at the strike price.
- It is generally suited for periods of neutral to moderately bullish market expectations for the underlying stock market asset.
Formula and Calculation
The profit or loss from selling covered calls can be calculated by considering the stock's purchase price, the option's strike price, and the premium received.
Maximum Profit (if stock price is at or above strike price at expiration):
Maximum Loss (if stock price falls to zero):
Break-even Point:
Where:
- Strike Price: The price at which the underlying stock can be sold if the option is exercised.5
- Stock Purchase Price: The original price paid for the shares of the underlying asset.
- Premium Received: The cash received by the seller for writing the call option.
- Expiration Date: The date by which the option holder must exercise their right, after which the option expires worthless.4
Interpreting Selling Covered Calls
When engaging in selling covered calls, investors interpret the strategy based on their outlook for the underlying stock. If an investor expects the stock to trade sideways or experience a slight increase, selling covered calls allows them to collect the premium as additional income without necessarily sacrificing significant capital gains. The collected premium acts as a buffer, reducing the effective cost basis of the shares and providing limited downside protection. This approach is often integrated into a broader portfolio management strategy to enhance returns on long-term holdings or to generate cash flow from a stagnant position. However, if the stock's price rises significantly above the strike price, the investor's upside is capped at that strike price plus the premium, as the shares would likely be called away.
Hypothetical Example
Consider an investor who owns 100 shares of XYZ Corp., purchased at $50 per share. The current market price of XYZ is also $50. The investor believes XYZ's price might not rise significantly in the short term, but they wish to generate additional income.
- Action: The investor sells one call option contract (representing 100 shares) on XYZ Corp. with a strike price of $55 and an expiration date one month away. They receive a premium of $2.00 per share, or $200 for the contract ($2.00 x 100 shares).
- Scenario A (Stock price below strike price): At expiration, XYZ Corp. is trading at $53. The call option expires worthless because the market price is below the $55 strike price. The investor keeps their 100 shares of XYZ Corp. and the $200 premium. Their profit from the covered call strategy is $200 (minus any commissions). They still own the shares, which are now worth $53 per share, having gained $3 per share in value.
- Scenario B (Stock price above strike price): At expiration, XYZ Corp. is trading at $58. The call option is "in the money" and the investor's shares are "called away" (assigned) at the strike price of $55. The investor sells their 100 shares at $55.
- Profit from stock appreciation: ($55 - $50) x 100 shares = $500.
- Profit from premium: $200.
- Total Profit: $500 + $200 = $700 (minus commissions).
- The investor misses out on the additional $3 per share appreciation above $55 (i.e., $58 - $55 = $3), which would have been an extra $300 if they hadn't sold the covered call.
This example illustrates how selling covered calls generates income but caps potential upside gains.
Practical Applications
Selling covered calls is a widely used strategy among investors for several practical purposes. One common application is for income generation from a long-term stock portfolio, particularly for dividend stocks or stocks where significant short-term appreciation is not anticipated. The premiums collected can supplement existing income streams or offset other portfolio costs. Additionally, it can serve as a limited risk management tool, providing a small buffer against moderate price declines in the underlying shares, as the collected premium effectively reduces the investor's cost basis. Financial institutions and sophisticated investors also use covered calls as part of broader portfolio management strategies to fine-tune exposure or to express specific market views. Investors interested in learning more about investing responsibly should consult resources from regulatory bodies.3 For instance, Charles Schwab also provides insights into how the strategy can be applied to potentially earn income or manage existing stock positions.2
Limitations and Criticisms
While selling covered calls offers benefits, it comes with notable limitations and criticisms. The primary drawback is that the strategy caps the potential upside profit of the underlying stock. If the stock's price rises sharply above the strike price, the investor's shares will likely be called away, meaning they miss out on any appreciation beyond that point. This can lead to underperformance compared to a simple buy-and-hold strategy in strongly rising markets.
Furthermore, while the premium provides some downside protection, it is limited. If the underlying stock experiences a significant decline, the investor still incurs losses on their shares, partially offset by the premium received. Selling covered calls also introduces complexities related to tax implications, as premiums are typically taxed as short-term capital gains, which may have a less favorable tax treatment than long-term capital gains. The strategy also requires active management, as new calls must be written after the expiration or assignment of old ones, potentially increasing transaction costs. Some analyses suggest that, over the long term, the trade-off of capped upside may not always be adequately compensated by the collected premiums, especially when considering the opportunity cost of missed significant rallies and the impact of volatility on option pricing.1 This can impact the overall effectiveness of hedging against market movements.
Selling Covered Calls vs. Naked Call
Selling covered calls and a Naked Call are both options selling strategies involving call options, but they differ fundamentally in their risk profiles and the investor's underlying position.
| Feature | Selling Covered Calls | Naked Call |
|---|---|---|
| Underlying | Investor owns the underlying asset (e.g., 100 shares of stock). | Investor does not own the underlying asset. |
| Risk Profile | Defined and limited downside risk (stock price to zero, offset by premium); capped upside. | Unlimited theoretical loss potential if the stock price rises significantly. |
| Capital Req. | Requires capital to purchase the underlying stock. | Requires margin capital, often substantial. |
| Purpose | Income generation, moderate risk management, or target selling price. | Speculation on a significant decrease in the stock's price or expectation of no movement. |
| Assignment | If assigned, existing shares are sold. | If assigned, shares must be purchased at market price and then sold at the strike price, potentially resulting in a large loss. |
The key distinction lies in the "covered" aspect: owning the underlying stock provides protection against the potentially unlimited losses that can occur if a call option sold naked (without owning the underlying) moves deeply into the money. A naked call is considered a much riskier strategy, primarily used by experienced traders with a strong conviction that the underlying asset's price will not rise significantly.
FAQs
What happens if the stock price goes above the strike price when I sell a covered call?
If the stock price goes above the strike price by the expiration date, the buyer of your call option will likely exercise their right to buy your shares at the strike price. Your shares will be "called away" from you, meaning you sell them at the strike price, regardless of how high the market price has risen. You keep the initial premium received.
Can I lose money selling covered calls?
Yes, you can lose money. While selling covered calls provides some downside buffer due to the premium received, if the underlying stock price falls significantly below your purchase price (and below the break-even point), you will still incur a loss on your stock holdings. The premium only partially offsets this loss.
Is selling covered calls suitable for all investors?
Selling covered calls is often considered a relatively conservative options strategy compared to others, but it is not suitable for all investors. It requires an understanding of options contracts and an acceptance of capped upside potential. Investors who are highly bullish on a stock and expect significant appreciation may find it limits their returns. It is often favored by investors seeking consistent income generation from existing stock positions.
What is the difference between a call option and a put option?
A call option gives the holder the right, but not the obligation, to buy an underlying asset at a specified strike price before a certain expiration date. A put option, conversely, gives the holder the right, but not the obligation, to sell an underlying asset at a specified strike price before a certain expiration date. When you are selling covered calls, you are selling a call option.