What Are Covered Calls and How Do They Work?
Understand covered calls: an options strategy to potentially generate income from your stock portfolio. Learn how this financial tool operates.
Options trading involves financial contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific timeframe. These contracts are versatile financial instruments used for various purposes, including speculation, hedging, and income generation. Among the numerous strategies available, the covered call stands out as a common approach often employed by investors seeking to generate income from their existing stock holdings.
Defining a Covered Call
A covered call is an options strategy where an investor sells call options against shares of stock they already own. The term “covered” indicates that the seller possesses the underlying shares, meaning they have the stock readily available to deliver if the option buyer chooses to exercise their right to purchase. This ownership of the shares significantly reduces the potential for unlimited losses that an uncovered, or “naked,” call option might entail.
The fundamental structure of a covered call involves pairing the ownership of 100 shares of a particular stock with the simultaneous sale of one call option contract for that same stock. This ratio is important because each standard equity option contract typically represents 100 shares of the underlying security. By holding the shares, the investor ensures they can fulfill the obligation if the option is exercised. The strategy aims to generate income from the premium received while potentially limiting upside gains on the stock.
The Mechanics of a Covered Call
The investor must own the underlying stock, typically in lots of 100 shares for each option contract they intend to sell. The call option contract specifies the conditions under which the buyer can purchase these shares. This contract includes a defined strike price, which is the predetermined price per share at which the underlying stock can be bought or sold if the option is exercised.
The expiration date marks the final day the option contract remains valid. After this date, the option expires worthless if not exercised. When an investor sells a call option, they immediately receive a payment known as the premium. This premium is the income generated from initiating the covered call strategy and is deposited into the investor’s brokerage account, typically within one to two business days following the trade execution.
The process of selling the call option involves instructing a brokerage firm to write and sell the contract on an options exchange. The investor effectively grants the option buyer the right to purchase their 100 shares at the specified strike price anytime before or on the expiration date. The premium received compensates the seller for taking on this obligation and for potentially capping their profit if the stock price rises significantly above the strike price.
Understanding Covered Call Outcomes
The outcome of a covered call strategy depends on the underlying stock’s price relative to the option’s strike price as the expiration date approaches. If the stock price is significantly above the strike price at expiration, the option is considered “in-the-money,” and the option buyer will likely exercise their right to purchase the shares.
In this scenario, the covered call seller will be “assigned,” meaning they are obligated to sell their 100 shares at the strike price, regardless of the current market price. The seller keeps the initial premium received and realizes a profit up to the strike price plus the premium, but they forego any additional gains above the strike price.
Conversely, if the stock price is at or below the strike price by the expiration date, the option will be either “at-the-money” or “out-of-the-money.” In these instances, it is not advantageous for the option buyer to exercise, as they could purchase the shares at a lower price in the open market. Consequently, the option expires worthless. When the option expires unexercised, the covered call seller retains both the initial premium received and their 100 shares of the underlying stock. This allows the investor to continue holding the shares and potentially sell another covered call option to generate additional income in the future.