What Are Covered Calls and How Do They Work?
Gain a clear understanding of covered calls. Explore this options strategy's fundamental principles, practical application, and financial considerations.
Options are financial contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specific date. These contracts can seem complex, yet they offer versatile strategies for investors to manage their portfolios and potentially generate income. Among the many options strategies available, covered calls stand out as a popular approach.
Understanding Covered Calls
A covered call strategy involves two components: owning shares of an underlying stock and simultaneously selling a call option against those shares. An investor owns at least 100 shares of a specific stock for each call option contract they intend to sell, as one options contract controls 100 shares.
A call option grants its holder the right to purchase the underlying stock at a specified price, known as the strike price, up until a certain date, called the expiration date. The seller of the call option takes on the obligation to sell their shares at that strike price if the option holder chooses to exercise their right. This arrangement allows the stock owner to generate income from their existing stock holdings.
The term “covered” means the investor already possesses the shares required to fulfill the obligation if the call option is exercised. This ownership mitigates the risk of unlimited losses that could arise from selling a “naked” call option, where the seller does not own the underlying shares. By holding the stock, the investor has the means to deliver the shares if called upon, providing a layer of security to the strategy.
Mechanics of Covered Calls
Implementing a covered call strategy begins with an investor owning at least 100 shares of a stock they are willing to sell. The investor then sells a call option contract corresponding to those shares. Upon selling the call option, the investor immediately receives an amount of money known as the premium, which is deposited into their brokerage account. The primary objective of selling a covered call is to earn this premium income.
What happens next depends on the stock’s price movement relative to the option’s strike price by the expiration date. If the stock price remains below the strike price at expiration, the call option will expire worthless. In this scenario, the investor retains both their original 100 shares of stock and the entire premium received from selling the option. For instance, if an investor bought shares at $50 and sold a $55 strike call option for a $2 premium, and the stock is trading at $53 at expiration, the option expires unexercised. The investor keeps the shares and the $200 premium.
Conversely, if the stock price rises above the strike price by expiration, the call option will likely be exercised by the option holder. This means the investor is obligated to sell their 100 shares at the predetermined strike price, regardless of how high the market price has risen. For example, if the investor bought shares at $50 and sold a $55 strike call option for a $2 premium, and the stock is trading at $58 at expiration, the shares would be sold at $55. The investor’s total proceeds would be $55 per share plus the $2 premium, totaling $57 per share.
Key Aspects of Covered Calls
Investors use covered calls to generate income from stocks they already own or intend to hold for an extended period. This strategy is particularly appealing in market conditions where the stock price is expected to remain relatively stable or experience only a modest increase. The premium received provides a consistent revenue stream, which can enhance overall portfolio returns, especially for long-term investors.
Selling covered calls limits the potential upside profit on the underlying stock. If the stock price significantly increases above the strike price before expiration, the investor’s gain is capped at the strike price plus the premium received. This means that while the strategy generates income, it foregoes any additional profit from substantial stock price appreciation beyond the strike price. For example, if shares were purchased at $50, a $55 strike call sold for a $2 premium, and the stock jumps to $70, the investor still only sells their shares at $55 and keeps the $2 premium, missing out on the rally above $55.
The premium received from selling a covered call offers a small buffer against a decline in the stock’s price. This means the stock can fall by the amount of the premium before the investor starts to incur a net loss on the position. However, this premium provides only limited downside protection and does not shield the investor from significant drops in the stock’s value. If the stock price falls substantially below the purchase price, the investor will still experience losses on their stock holdings, despite the premium income.
A final consideration is the possibility of the stock being “called away.” If the stock price is above the strike price at expiration, the investor’s shares will be sold at the strike price. This can be an important factor if the investor had a long-term intention to hold the stock for its future growth or dividends. Once the shares are called away, the investor no longer owns them and would need to repurchase them at the current market price if they wished to re-establish their position.