A covered call strategy is a popular options trading technique used by investors to generate additional income from their stock holdings. This article will explore the fundamentals of covered calls, provide a real market covered call example, discuss the pros and cons, and guide you on the best times to use this strategy. Let’s start from the first question: what is a covered call?
Key takeaways
- A covered call is a popular options strategy that generates income through options premiums, ideal for investors seeking consistent cash flow.
- This strategy involves holding a long position in an asset and selling call options on it, suitable for those who don’t anticipate significant price increases soon.
- Covered calls are great for investors who expect minimal upward movement in the underlying stock price over the near term, allowing for long-term asset retention while earning premiums.
What Is a Covered Call?
What is a covered call? Simply put, a covered call strategy is simple yet effective for generating income. It involves selling a call option on a stock that the investor already owns. This means the investor retains ownership of the stock while earning a premium from the sold option.
Covered Calls Explained
Here’s how you sell covered calls:
- Stock Ownership: The investor holds a long position in the stock, meaning they own the shares.
- Selling the Call Option: They sell (write) a call option on these owned shares.
By owning the stock, the investor is “covered,” meaning they can deliver the shares if the option buyer chooses to exercise their right to buy.
Slightly Bullish (or Neutral) Market Strategy
The covered call strategy is typically used by investors with a neutral to slightly bullish short-term outlook on the stock. If you believe the stock price will stay relatively flat or increase slightly, this strategy can be beneficial. It allows you to generate extra income without selling your shares. To better understand what we mean, take a look at the typical profit and loss (P&L) profile of a covered call strategy:
Note the two most important things:
- Your profit potential is capped
- Your loss potential is uncapped
Little by little, our article will guide you to develop a better understanding of this strategy and its P&L structure.
Sell Covered Calls for Income Generation
The primary advantage of selling covered calls is the premium received from the call option. This premium represents an additional income stream, which adds to the overall return on the investment. For example, if you own 100 shares of a stock trading at $50 and sell a call option with a strike price of $55 for $2 per share, you collect $200 in premiums right away.
Obligations and Potential Outcomes
When you sell covered calls, there are a few possible outcomes based on the stock’s price movement. First of all, if the stock price remains below the strike price, this is what happens:
- The call option expires worthless.
- You keep the premium and still own the stock.
Second, the stock price may equal the strike price. We understand that this is a rather theoretical case (the chances that the price is exactly equal to the strike of your option are really low), but this is what would happen:
- The call option is exercised.
- You sell the stock at the strike price, keeping the premium plus any appreciation up to the strike price.
The stock price may also move above the strike price. In this case, you’d have the following scenario:
- The option buyer exercises their right to buy the stock.
- You must sell the shares at the strike price, missing out on potential gains above this level. However, you still keep the premium received. Note that, in this case, your net profit will still be positive (although it will be capped, and lower compared to what you would have earned if you had simply owned the stock)
As you may guess, the stock price may move below the breakeven price. This is the worst-case scenario, but you should take it into account before opening the trade:
- You will make a loss on the stock, mitigated by the premium you received.
- Note that, in this case, your losses are not capped, but just reduced by the premium you received.
- You still keep the stock, which can appreciate in value in the future. This is something you should keep in mind: you generally don’t want to go with a covered call strategy on a stock you are not confident holding for the long term if things go south.
A Covered Call Example from a Real Market Scenario
Consider DELL, a company you may like for its solid financial position and consistent earnings track record. After thorough research, you decide to buy 100 shares at the current market price of $125.79.
You’ve been following DELL’s stock for months, building confidence in your understanding of its price dynamics. This makes you comfortable enough to sell covered call options while holding the shares in your portfolio.
Setup of the Covered Call Strategy
Let’s break down the covered call example using our actual market scenario:
- Stock Purchase: Buy 100 DELL shares at $125.79 each.
- Call Option Sale: Sell a $115 call option at $13.
Our options screener would give you this P&L profile:
Here’s how this transaction looks:
- Premium Received: Selling the call earns you $13 per share, totaling $1,300 (since each option contract covers 100 shares).
- Breakeven Price: Your breakeven price is calculated by subtracting the premium received from the stock purchase price, which is $125.79 – $13 = $112.79.
Note that your maximum profit would correspond to a 1.96% return (or 28.24% if annualized).
Profit and Loss Analysis
You want DELL’s stock price to stay above $112.79 to avoid losses. Here are the potential outcomes:
- Stock Price Below Breakeven ($112.79): You incur losses, but they’re reduced by the $1,300 premium.
- Stock Price Between Breakeven ($112.79) and Strike Price ($115): You keep the premium with a loss on the stock, generating a small profit or breaking even.
- Stock Price Above Strike Price ($115): Here, your gain is capped. On the one hand, you have a profit of ($125.79 – $115) * 100 = $1,079 (exclusive of the premium). On the other hand, you’ll have to sell your shares at $115, missing out on any further appreciation in case the price continues to rise. To simplify this, your max profit will simply be the strike price ($115) minus the breakeven price ($112.79), so $2.21 multiplied by 100 ($221). Note that if the stock trades significantly above the strike price, there’s a chance you’ll miss out on a more substantial portion of gains compared to just holding onto the stock (and not selling covered calls).
Strategy Adjustments Based on Market Conditions
In this covered call example, the call option expires in a month. However, expiration dates can be adjusted based on your strategy.
Consider DELL’s stock price below:
DELL’s stock has been declining recently, so you might opt for a shorter expiration date (e.g., 1-2 weeks) to limit exposure and potential losses. Or, why not, you could evaluate a different company to set up this strategy.
Covered Calls Explained – Pros and Cons of Trading Covered Call Options
As we tell you below, there are different pros and cons to consider when trading covered call options. This popular options strategy, while effective in generating income, comes with its own set of advantages and drawbacks. Here’s a table that sums it up:
Pros of Trading Covered Call Options
Consider these pros before trading a covered call:
Income Generation
One of the most attractive benefits of the covered call strategy is generating additional income from premiums. When you sell covered calls, you receive a premium for the call options sold, which can enhance your overall return on investment. This makes it an appealing strategy for those looking to boost their income without selling their existing stock holdings.
Risk Mitigation
Owning the underlying stock limits potential losses compared to naked call options. In a naked call scenario, the seller faces unlimited risk if the stock price skyrockets. However, with a covered call, the investor is “covered” by the stock they already own, thus mitigating the risk. This is why covered calls are often seen as a relatively safer options strategy.
Relative Ease
Setting up and managing a covered call position is straightforward. All you need to do is own shares of the stock and then sell call options against those shares. This simplicity makes it accessible even for beginners who may not be well-versed in more complex options strategies.
Repetition
Another advantage is the ability to repeatedly sell calls on the same stock. If the options expire worthless, you retain your shares and can sell new call options again. This repetitive process allows investors to generate consistent income over time while still holding onto the underlying asset.
Cons of Trading Covered Call Options
Here are the cons of the covered call strategy:
Limited Upside
One significant drawback is the limited upside potential. If the stock price rises significantly, the gains you can realize are capped at the strike price of the sold call option. For instance, if you sell a call with a strike price of $50 and the stock soars to $70, you miss out on the $20 per share gain above the strike price. Therefore, this strategy may not be suitable for very bullish investors who expect substantial appreciation in the stock price.
Need for Capital
To employ a covered call strategy, you need to own the underlying stock, which requires substantial capital investment. Unlike other options strategies that might involve only the cost of the option premium, covered calls necessitate buying (or already owning) the shares, which can be a barrier for investors with limited funds.
Market Volatility
Covered call strategies can be affected by market volatility. In highly volatile markets, stock prices can fluctuate wildly, which may lead to unexpected outcomes. If the market takes a downturn, the stock price could fall below the strike price, leaving the investor with potential losses on the shares owned.
Not Suitable for Bullish Outlooks
If you have a very bullish outlook on a stock, the covered call strategy may not be the best choice. This is because the strategy limits the potential upside gains. Investors anticipating a significant rise in the stock’s price might prefer other strategies, such as holding the stock without writing options or using different options strategies that don’t cap the profit potential.
Find the Best Moment to Use the Covered Call Strategy
We don’t want you to think that a covered call is a safe strategy that you can perform every month without caring too much for your risk. Instead, learn to distinguish the best (and worst) moments to use the covered call strategy:
Minimal Expected Stock Movement
A covered call strategy works best when you don’t expect significant price movement in the stock. If you believe the stock will trade relatively flat, staying below the strike price but not falling much either, you can collect premiums without compromising much on potential gains. For instance, if your analysis shows that a stock will hover around its current price, selling covered calls can be quite profitable. Alternatively, if you’re expecting large price swings, consider the straddle option strategy for broader market conditions.
Income Generation
For investors looking to generate additional income, covered call options are a valuable tool. Selling call options allows you to earn premiums, effectively creating an extra stream of income from stocks you already own. It’s like receiving a dividend from the stock, even if it doesn’t pay one. Another income-generating method is the covered put strategy, which focuses on downside protection and premium collection in falling markets.
Tax-Advantaged Accounts
If you’re from the US, trading covered calls within tax-advantaged accounts like IRAs can be particularly beneficial. While generating income and potentially having the stock called away can create tax liabilities in regular accounts, doing so in a tax-advantaged account helps you avoid or defer these taxes. This makes the strategy even more attractive for long-term income generation.
Remember: Sometimes It’s Better to Avoid the Covered Call Strategy
You probably saw this coming: there are also (at least) a couple of cases in which it’s better not to use the covered call strategy.
- Expecting a Stock Rise: If you believe the stock will increase significantly soon, avoid selling covered calls. It’s wiser to hold the stock and benefit from its potential growth rather than capping your gains for a relatively small premium.
- Serious Downside Risk: If the stock looks likely to drop substantially, don’t use covered call options just to get extra cash. It’s better to sell the stock and move on or consider short selling to profit from its decline.
Our predefined scans look for some good scenarios to set up a covered call strategy. This should never replace your personal analysis or common sense, though. Only use the covered call strategy if it matches your personal risk tolerance and general investment strategy.
