Covered Call Option Strategy
If you are just starting out in investing, it is important to learn different strategies to expand your knowledge and optimize your portfolio. In this blog, you will learn all about the “covered call“, a popular options strategy that you can use to generate additional income from your stock portfolio. We will also briefly discuss some related terms, such as covered put, covered options and covered call spread. Let’s get started!What is a covered call?
A covered call is an options strategy where you sell a call option on a stock while owning the underlying stock. The goal of this strategy is to generate additional income from the premium received from the option, without the risk of an uncovered call. Here is a quick overview of the key terms:- Call option: A contract that gives the buyer the right, but not the obligation, to buy a certain number of shares at a predetermined price (strike price) on or before a specific date (expiration date).
- Option premium: The amount the buyer of an option pays the seller to obtain the right granted by the option.
How does a covered call work?
Suppose you have 100 shares of company X in your portfolio and you believe that the share price will not rise much in the near future. You can then sell a call option and receive the option premium as additional income. If the share price does not rise above the option strike price, you keep the premium and continue to own the shares. If the share price does rise above the strike price, the buyer of the option can decide to exercise the option and buy the shares from you at the strike price. In this case, you sell the shares and still keep the premium received.
The covered call strategy is especially suitable for investors with a neutral to slightly bullish short-term market view. It is important to know that this strategy is not suitable for shares that are highly volatile or shares that you expect to rise significantly in value.
Benefits of a covered call
- Additional income: By selling call options, you receive additional income in the form of option premiums, which can be attractive in a market with low interest rates.
- Risk reduction: A covered call reduces the risk compared to simply holding shares, because the premium received serves as a buffer against price declines in the underlying share. This makes the strategy suitable for investors who are looking for some protection against market volatility.
- Flexibility: Covered calls can be adapted to different market conditions, risk tolerance and investment goals by choosing different strike prices and expiration dates for the options.
- Lower transaction costs: Since you already own the underlying shares, you do not have to buy additional shares to cover the call option. This can result in lower transaction costs compared to other options strategies that require buying or selling shares.
Risks and disadvantages of covered calls
Limited upside potential
If the stock price rises sharply, you run the risk of selling the shares at the strike price, potentially missing out on future profits. This is a significant disadvantage of the strategy, as you give up the potential for unlimited profits in exchange for the option premium received.Loss protection
Although the premium received provides some protection against price declines, the loss can still be significant if the underlying stock price falls sharply. In this case, the premium may not be enough to offset the loss. It is therefore important to combine the covered call strategy with other risk management techniques, such as setting stop-loss orders.When to Use and When Not to Use a Covered Call
A covered call can make sense in a number of scenarios, including the following:- You expect the stock to move little: With a covered call, you don’t want the stock price to rise above the option strike price, at least until after the option expires. If the stock remains more or less stable, you can still collect the option premium and not lose much, if any, of your profits.
- You want to generate income from a position: If you want to take advantage of the relatively high price of option premiums, you can set up a covered call and generate income. In effect, it’s like creating a dividend from a stock.
- You’re trading in a tax-efficient account: When you use covered calls, you generate income and you may have called away the stock, both of which can create tax liabilities. Setting up covered calls within a tax-advantaged account such as an IRA can therefore be attractive, allowing you to avoid or defer taxes on these profits.
When to Avoid a Covered Call
A covered call is probably best avoided in the following situations:- You expect the stock to rise in the short term: There is little point in giving away the potential return of a stock in exchange for a relatively small amount of money. If you think a stock is about to rise, you are probably better off holding on to it and letting it rise. After it has risen significantly, you may want to consider setting up the covered call.
- The stock has a lot of downside risk: If you own a stock, you generally expect it to rise. However, don’t use a covered call to get extra money from a stock that looks like it will fall significantly in the short or long term. It is probably better to sell the stock and move on, or you can try to short sell the stock and profit from the decline.
Related Terms and Strategies
Covered Put A covered put is similar to a covered call, but instead of selling call options while holding the underlying stock, you sell put options while holding a short position in the stock. This can generate additional income and reduce the risk of the short position somewhat. Covered Options Covered options refers to both covered calls and covered puts. These are options strategies where the seller of the option holds the underlying stock or a short position in the stock, thereby reducing risk.
Covered Call Spread
A covered call spread is a more advanced options strategy where you simultaneously buy and sell a call option with different strike prices or expiration dates. This can further reduce risk and tailor the return on the strategy to your specific market expectations.
Covered Call – An Example
Let’s look at an example to see how a covered call works. Imagine you own 100 shares of a hypothetical company called XYZ, which is currently trading at $45 per share. You decide to write a covered call with a strike price of $50 and a premium of $1.50.Scenario 1: Stock Stays Below Strike Price
If stock XYZ does not reach the strike price of $50, you have earned 100 x $1.50 = $150. The option expires worthless, and you keep both your shares and the premium you received. In this case, by writing the covered call, you have successfully generated an additional return in addition to the value of your shares.Scenario 2: Share rises above the strike price
Suppose that share XYZ rises above €50 before expiration. In that case, you will have to sell the shares for the strike price of €50, if you are appointed. Your maximum profit is then the received premium of €150 (100 x €1.50), and you have given up the potential benefit of a price increase above the strike price. In the best scenario, the price rises to €50. In that case, you have both (paper) profit on your shares and on the written call. You can choose to sell to realize a price profit. But you can also choose to close the option at a higher premium (for example €2) than the originally received premium. You can then sell a new XYZ call with a longer term, for example with an exercise price of €60 at a premium of €1.50. This is also known as a “rollover.” This example shows how a covered call can be used to generate additional income from stocks, beyond any dividends or capital gains. However, it is important to remember that you run the risk of having to sell your stocks before the strike price, potentially missing out on future price increases.