A covered call is a trading strategy where an investor holds a long position in an asset (such as stocks) and sells call options on that same asset in an attempt to generate additional income.
It is considered a moderately conservative strategy, often used by investors who are neutral to slightly bullish on the underlying asset.
BULLISH OR NEUTRAL OUTLOOK
The covered call strategy is often employed when an investor believes that the price of the underlying stock will remain relatively stable or show only modest appreciation.
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The strategy is also suitable for investors who are moderately bullish on the stock but do not expect a significant price increase.
LIMITED PROFIT POTENTIAL
By selling call options, the investor caps their potential profit if the stock price rises above the strike price of the call options.
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The maximum profit is achieved when the stock price is at or below the strike price at expiration.
RISK MANAGEMENT
Investors should be comfortable with the possibility of having to sell their stock if the stock price rises above the strike price of the call options.
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The covered call strategy may not be suitable for stocks with significant potential for capital appreciation.
PROS | CONS |
Income Generation: The primary goal of a covered call strategy is to generate income through the premiums received from selling call options. This strategy can be particularly attractive in a sideways or slightly bullish market, where the underlying asset's price is relatively stable. | Limited Upside Potential: The main drawback of covered calls is that the strategy limits the potential for profit. If the price of the underlying asset rises significantly, the investor's gains are capped at the strike price of the call option. |
Risk Reduction: The sale of call options provides some downside protection, as the premium received reduces the net cost of holding the underlying asset. If the price of the underlying asset remains below the strike price of the call options, the investor retains the premium and the underlying asset. | Obligation to Sell: By selling call options, the investor takes on the obligation to sell the underlying asset at the strike price if the option is exercised. This could result in missed gains if the asset's price rises substantially. |
Enhanced Returns in Stable Markets: Covered calls can be profitable in markets with low volatility or when the underlying asset has a steady, incremental price increase. | Complexity and Monitoring: Covered call strategies require active management and monitoring of market conditions. Constant attention is needed to adjust positions as the market evolves. |
COVERED CALL AND OPTION ASSIGNMENT
Assignment can occur if the price of the underlying asset rises above the strike price of the call option and the option buyer decides to exercise their right to buy the asset.
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If assigned, the investor must sell the underlying asset at the strike price, even if it means selling at a lower price than the current market value, for example:
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An investor owns 100 shares of DIA stock, currently trading at $347.47 per share.
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The investor sells a covered call with a strike price of $350.
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If the price of DIA rises above $350 and the call option buyer decides to exercise the option, the investor is obligated to sell the 100 shares of DIA at $350 per share.
Assignment risk is more relevant for the seller (writer) of options, especially for strategies like covered calls, where the investor sells call options against an existing long stock position.
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COVERED CALL EXAMPLE
Suppose an investor holds a bullish view on the SPDR Dow Jones Industrial Average ETF Trust (DIA) for the upcoming nine days but doesn't think the price will move very much. Envisioning the stock's current trade at $347.47 per share, the strategy chosen to express this bullish to neutral outlook involves the execution of a covered call strategy. In this scenario:
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Sells for $2.46 one call option with a strike of $350 expiring in nine days
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Buys 100 shares at the underlying price of $347.47 per share
This strategic move results in a net credit of $2.46 for the single option, derived from the sale of the $2.46 credit. In this scenario, the investor purchases 100 shares of the stock amounting to $34,747. Considering the standard equivalence of one options contract to 100 shares of the underlying asset, the overall credit accumulated stands at $246 with a total risk of $34,501 when subtracting the total credit of $246 from the purchased amount of $34,747.
MAXIMUM PROFIT SCENARIO
Suppose DIA experiences a neutral uptrend, reaching the breakeven of $345.01 at the time of expiry. This results in the attainment of potential profit, amounting to a total limit of $499. This limit is obtained by first calculating the difference between the underlying ($347.47) and short strike ($350). After calculating the difference, the result is multiplied by 100. Finally, this amount is subtracted from the entry credit ($246). To reach this limit by expiry, the underlying stock price has to first surpass the breakeven of $345.01. This breakeven at expiry price is achieved by first retrieving the underlying price (347.47) and then multiplying the result by the number of shares (100) subtracted by the entry credit ($246) and finally dividing the total amount by 100 to get a total of $345.01 as the breakeven price at expiry.
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((Entry Credit - (Underlying - Short Strike) x 100)) = Maximum Profit
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(($246 - ($347.47 - $350) x 100)) = $499
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((Underlying Price x 100) - Entry Credit) / 100 = Breakeven Price at Expiry
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(($347.47 x 100) - $246) / 100 = $345.01
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It's important to note that once the stock surpasses the breakeven price at expiry, the strategy will continue to generate profit until it plateaus at a total of $499, and no additional profit accrues beyond this point.
MAXIMUM LOSS SCENARIO
Should the DIA shares hover below $345.01 by expiry, the potential maximum loss comes into play. Yet, this loss will continue to a maximum limit of $34,501 until the position is closed or assigned and then multiplied by 100 shares.
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Capped Potential Loss
The investor's undesirable scenario envisions the stock concluding below the $345.01 per share mark upon expiration, thus marking the maximum potential loss for this investor of $34,501.
BREAKEVEN POINT
The breakeven point for a covered call strategy is calculated by subtracting the premium received from the purchase price of the stock. Here's the step-by-step breakdown:
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Stock Purchase Cost: $347.47 per share
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Premium Received: $2.46 per share
In this example, if the DIA price at expiration is above $345.01, the investor begins to profit. The maximum profit is capped at $499, occurring when the stock price is at or above the strike price of $350. If the price drops below $345.01, the investor starts to incur losses, with the worst-case scenario resulting in a maximum loss of $34,501.
The covered call strategy presents an attractive option for investors seeking to enhance income from their existing stock holdings, particularly when anticipating stable or modestly bullish market conditions. By selling call options against stocks they already own, investors can generate premiums that add to their overall returns. This strategy, while limiting potential gains if the stock price rises significantly, provides a cushion against downside risk through the premiums received. It's essential for investors to weigh the income generation potential against the obligation to sell the underlying asset if the stock price surpasses the call option's strike price. This balanced approach makes covered calls a valuable tool in managing portfolio risk and income generation in various market scenarios.
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- “Options Trading: Basics of a Covered Call Strategy.” Schwab Brokerage, www.schwab.com/learn/story/options-trading-basics-covered-call-strategy.
- “What Is a Covered Call?” Fidelity, 9 May 2024, www.fidelity.com/learning-center/smart-money/covered-call.
- “Options Strategy: The Covered Call.” Schwab Brokerage, www.schwab.com/learn/story/options-strategy-covered-call.
- Anatomy of a Covered Call. www.fidelity.com/learning-center/investment-products/options/anatomy-of-a-covered-call.
- “Covered Call.” Corporate Finance Institute, 20 Feb. 2024, corporatefinanceinstitute.com/resources/derivatives/covered-call/.
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