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Covered Calls

Summary

The covered call strategy involves owning or buying stock and selling an appropriate number of calls against it.

It is a slightly bullish to neutral strategy.

It can generate extra income in your account and potentially reduce volatility.

It is equivalent to a short put.

The maximum gain is limited; the risk is the same as owning the stock (minus the credit for selling the calls).

Would you like to...

  • Generate income in neutral or rising markets?
  • Get paid to sell your long stock position?

You own a stock that is part of your long-term investment portfolio. You like it long term, but don't see it going anywhere over the short term and would consider selling it, given the right terms. You would also like to generate some income, but you aren't interested in selling your stock only to buy a CD with a next-to-nothing return.

Given these conditions, many self-directed (or "retail") traders use covered calls to generate income in their accounts. It is highly conservative and therefore widely popular. In fact, many stock traders begin trading options this way. The strategy can also be used to finance purchasing long stock positions: if used in conjunction, it is known as a "buy-write," when the investor buys the stock and writes (or sells) the call. A covered call is equivalent to a cash-secured put.

What is a Covered Call?

Implementing the covered call strategy involves buying (or owning) 100 shares of a stock and then selling a call that is "covered" by the stock (since 1 options contract usually controls 100 shares of stock). The sale is a credit and adds cash to your account. But while selling the call brings income to the account, it creates the obligation to sell the stock if the call is assigned. Note that this his can create tax issues for stock with a low cost basis.

Covered calls are profitable within a defined range. They profit if the stock price drops by less than the amount of the sold call, and remain profitable if the stock moves up to or beyond the strike price of the call sold. The maximum gain is realized if the stock price is at the strike price. At that point, the full value of the sold call is retained while the stock has achieved its maximum without assignment.

Example: With the stock at 48, you sell a 50 call for $1. If the stock goes to $49.50, you gain $1.50 per share and keep the $1 of premium.

Covered call example

If the stock goes to 47.20, there is .20 of profit. Your stock would have lost $.80, but you gained $1 from selling the call option. Meanwhile, if the stock goes to 50.30 at expiration, the call will be assigned and the stock sold. You will recognize a $2.00 gain in the stock price and $1 profit from the option premium which you received; but of course you will have sold your stock.

If the sold call can be bought back for a small amount before expiration, it is usually best to do so, in order to lock in your profit and eliminate exposure to risk.

XYZStock P/LCall P/LCovered Call P/L
$40($8)$1($7)
$47($1)$1$0
$50$2$1$3
$60$12($9)$3

If you are purchasing stock at the same time you are selling calls, this strategy loses if the stock price drops significantly because to exit a position, you will need to first buy back the call and then sell the stock. In a falling market, this can be problematic. The credit from selling the call gives you small cushion, but not real downside protection. (If you are content to own the stock for the longer term, it then becomes the case that the options premium received offsetting the stock loss.)

Alternately, if the stock takes off and moves beyond the strike price sold, the position will not partake in those gains. You still make a profit, but there is the possibility of assignment before expiration. If you are assigned, you will have to sell your stock, which can create tax issues (especially if you have held the stock for a long time). If the stock price is above the strike price at expiration, you will be assigned.

To reiterate, the covered call will profit from the stock's moving up, staying flat, or falling no more than the credit from the sold call. The position will lose as the stock price moves down beyond the amount of the credit. Because implied volatility (the volatility expectation taken from the options price) is a significant part of the premium paid for an option, if implied volatility goes down, the covered call will profit, and if implied volatility goes up, it will lose. This is only the case before expiration, because at expiration profit and loss is fixed. Time is on your side with a covered call. You have a position with positive theta and so every day you are profiting from time decay (all else held equal).

Example of a Winning Trade

  • In the circled area, INTC price bounces off resistance at the same time that implied volatility spikes. We want to sell calls on high implied volatility because that is more time decay in our favor. Covered call winning trade
  • Time decay is the greatest in the front month, so in this case, with the stock at 23.50 and rising in mid-August, we would sell one month out: September 25 calls for $1.00.
  • If the underlying prices falls, and/or implied volatility drops (as is the case), it is usually best to buy back the call at some pre-determined value (say $.15).
  • As it happened, implied volatility fell quickly, but the stock price rose above $25. So in this case it is usually best to wait for expiration and assignment, because buying back the call can be very expensive. If we had waited, we would have had the $1 profit from the option and $1.50 from the rise in the stock price, a gain of more than 10% for the month (minus commissions and fees).

Example of a Losing Trade

  • Some people like to use ETFs (exchange traded funds) for covered calls to minimize risk, but that doesn't mean that there isn't any risk. Here is an example using the QQQQ. Covered call losing trade
  • Here, in late July, we seemed to have the price bottoming out, with a spike in implied volatility. The price breaks back above 48 as the implied volatility starts to fall, so we sell the August 49 call for $1.20.
  • After a quick move in our direction, the price dives down to below 46 as the implied volatility increases almost 50%. Now we have two options. If we decide that we want to get out of the entire position, then we need to first buy back the call, and then sell the stock. Otherwise we can wait until expiration if we think that the QQQQ will be back up above 46.80 (our break-even point) by expiration.
  • We hold the position and stock is down around $46 at expiration, so we have a loss, but it is reduced by the amount of the credit of the sold call.
Options involve risk and are not suitable for all investors. For more information, please read the Characteristics and Risks of Standardized Options. Copies may be obtained from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606 or call 1-888-OPTIONS or visit www.888options.com.

This material is being provided to you for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by OptionMonster Holdings. OptionMonster Holdings does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular investment or investment strategy, and you shall be fully responsible for any investment decisions you make, and such decisions will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs.

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