What Is a Covered Call and How Does It Work?
Explore the covered call strategy to generate income from your stock portfolio. Understand how this approach balances income potential with asset management.
A covered call is an options strategy where investors generate income from their stock holdings. It involves owning shares of a stock and selling a call option against those shares. This approach is popular for earning additional revenue from existing investments.
Understanding the Components of a Covered Call
Understanding a covered call strategy requires familiarity with its core financial components. The underlying stock refers to shares an investor already owns in a company, forming the foundation for the strategy.
A call option is a contract granting the buyer the right, but not the obligation, to purchase an underlying asset at a specified price within a defined timeframe. The investor selling the call option, known as the “writer,” takes on the obligation to sell their shares if the option is exercised. The strike price is the predetermined price at which the underlying stock can be bought or sold if the option is exercised.
The expiration date marks the final day an option can be exercised; after this date, it becomes void if unexercised. The premium is the income received by the seller for taking on this obligation, credited immediately upon sale.
How a Covered Call Operates
A covered call involves specific actions and obligations. An investor holding at least 100 shares of a stock can sell one call option contract for every 100 shares owned. For instance, if an investor owns 200 shares, they can sell two call option contracts. A standard stock option contract typically covers 100 shares.
Upon selling the call option, the investor immediately receives the premium from the option buyer. This premium represents direct income generated from existing stock holdings. The “covered” aspect means the investor already owns the shares necessary to fulfill the obligation if the call option is exercised. This ownership mitigates the unlimited risk associated with selling “naked” call options, where the seller does not own the underlying shares.
The investor incurs an obligation to sell their shares at the strike price if the stock’s market price rises above that strike price before the expiration date and the option is exercised. If this occurs, the shares are “called away,” meaning they are sold from the investor’s account at the predetermined strike price. The premium received at the outset acts as a small buffer against potential downward price movements of the underlying stock, offering a limited degree of protection.
Potential Outcomes of a Covered Call
The financial outcomes of a covered call strategy depend on the underlying stock’s price movement in relation to the strike price at the option’s expiration. If the stock price remains below the strike price at expiration, the call option typically expires worthless. The buyer would have no financial incentive to purchase shares at a price higher than the market value. The investor selling the option retains the premium received and continues to own the underlying stock.
Alternatively, if the stock price rises above the strike price at expiration, the call option is likely to be exercised, also known as “assigned.” This means the investor is obligated to sell their shares at the strike price, even if the market price is higher. The investor still keeps the initial premium received, but their potential profit from the stock’s appreciation is capped at the strike price plus the premium.
A third possibility involves the stock price being at or very near the strike price as the expiration date approaches. In this situation, the investor might choose to “roll” the option, which involves buying back the expiring call option and simultaneously selling a new call option with a later expiration date or a different strike price. This action allows the investor to potentially collect another premium and extend the strategy, or adjust their exposure to the stock’s price movements.
Considerations Before Implementing a Covered Call
Several factors warrant careful consideration before implementing a covered call strategy. The strategy offers immediate income through the premium but caps potential upside gains. If the stock’s value rises substantially above the strike price, the shares will likely be called away, preventing the investor from participating in further appreciation.
Investors remain exposed to downside risk on the underlying stock. While the premium received offers a limited buffer, it does not fully protect against significant declines in the stock’s price. If the stock experiences a sharp downturn, the investor can still incur substantial losses on their stock holdings, potentially exceeding the premium collected. The capital commitment required to engage in a covered call strategy is also a factor, as it necessitates owning at least 100 shares of the underlying stock for each option contract sold.
Understanding basic options terminology and market dynamics is important before using this strategy. Investors should also be aware that profits and losses from covered calls are considered capital gains for tax purposes, and these are reported on IRS Form 1099.