What are covered calls and how do they work?
Investing is all about making money. Some investors look for growth, some look for value, and some look for income, but they’re all looking to grow their wealth.
What if someone told you that no matter your investment strategy, you have the potential to expand your earnings and income from your holdings?
They would be telling you the truth!
With derivatives known as covered calls, investors with long positions in stocks are able to use them to generate income in the short term. These unique options trades offer the potential to earn cash immediately from shares you already own — but should you take part in them?
What Is a Covered Call Option?
A covered call option is a form of derivative investment that gives investors the ability to generate extra income from stocks they own and plan to own for some time.
The additional income is the result of an option premium paid by the call option buyer. As long as the price of the stock fails to reach the option’s strike price by the expiration date on the contract, the option premium is the seller’s to keep.
The difference between the traditional call options strategy and the covered call options strategy is that the seller owns the underlying stock. While the call writing party in a traditional call option doesn’t own shares of the underlying security, with covered calls, the call writer already owns the shares covered in the contract.
This offers two key benefits:
- Alleviates Downside Risk. With a call option, if the strike price is met, the option seller must sell the shares to the buyer at the predetermined price. As the price of the stock rises higher above the strike price, the losses for the seller on the trade become more significant. With a covered call, however, the downside risk is capped because the option seller isn’t forced to buy shares in the open market at the higher current price in order to complete their end of the trade — they already own the covered shares.
- Creates a Win-Win Trade. When writing covered call options, the seller sets the strike price. You can set a strike price well above the current price of the stock, often at a price at which you’d be happy to sell. If the strike price is met, you take profits on the trade. If not, you hold the shares and keep the premium, and you can write a new covered call if you wish. It’s a win-win.
How Do Covered Calls Work?
A covered call option works just like a call option contract. The seller agrees to sell the buyer 100 shares of stock at a predetermined price if the price of the underlying stock reaches or exceeds a strike price (the price at which the option is considered “in the money”).
The party selling call options earns an immediate premium for the options they sell. If the strike price is not met, they keep that premium as a profit.
On the other side of the coin, the investor buying call options stands the chance of earning a profit if the underlying stock reaches and then exceeds the strike price, triggering the potential to buy the stock at a predetermined, discounted price.
Example of a Covered Call
Let’s say John owns a long stock position of 1,000 shares of XYZ stock with an average purchase price of $20 per share. XYZ has a current market price of $22.5 per share. He’s not interested in selling his shares, but he is interested in generating income from them.
John decides that the best way to earn income from his shares is by becoming a covered call writer, since the stock moves at a relatively slow, predictable rate. He decides to write 10 call options (100 shares per option, meaning these 10 contracts cover 1,000 shares) with a $25 strike price.
When selling the call options, John earns a $0.75 premium per share, which nets him $75 per contract or $750 in premium income on the entire transaction. He receives this premium immediately and keeps it no matter how the trade goes.
The trade will end in one of two ways:
- Out of the Money. If XYZ fails to climb to $25 per share by the expiration date, the option will expire out of the money, and John keeps his shares. He will have gained an extra $75 per contract, minus contract fees.
- In the Money. If XYZ does climb above $25 per share, the option is in the money, meaning the buyer will exercise the option. John will be forced to sell his shares of XYZ for $25 per share.
Determining Breakeven on Covered Calls
To determine where John would hit breakeven status on his trade, use the formula below:
Strike Price + Option Premium – Brokerage Fee = Breakeven
For simplicity’s sake, let’s say John pays $0.01 per share in fees, even though most brokerages charge less than this for options contracts. In this case, his formula would look like:
$25 + $0.75 – $0.01 = $25.74 Breakeven
Based on his breakeven point, as long as the price of XYZ stock stays at or below $25.74, John made the right decision when he decided to sell covered calls. If the price exceeded $25.74, John would have been better off without the covered call options.
When Covered Calls Work Best
Although it’s possible to write covered calls for every stock in your portfolio, it’s not always the best idea to do so. As demonstrated above, there is a point for each option at which a covered call seller would be better off just holding onto the shares.
When determining whether you should write a covered call option, consider how much you believe the stock will grow in the future, paying close attention to historical data.
Covered call options are best when you believe the stock will fall, remain flat, or experience only minor gains in the near term. If you believe the stock has the potential to grow significantly in the near future, you’re likely better off avoiding a covered call trade. That’s because selling a covered call option on a stock that skyrockets can lock you into a selling price that causes you to miss out on significant gains.
Pros and Cons of Covered Calls
As with any other investment strategy, covered calls come with their own list of benefits and drawbacks. Although the potential income generated through these options is appealing, when you sell them, you’re effectively capping your earnings potential. Here are the most important pros and cons to consider.
Pros of Covered Calls
There are several benefits to using covered call options. Some of the most significant include:
- Volatility Protection. Volatility is a common and unavoidable market risk. However, through the use of covered call options, you’re adding a cushion for any fall that might take place. The premium paid by the call buyer acts as a buffer against losses if your position goes south.
- Income. Drawing income from your investments is an exciting concept. Covered calls offer exactly that, providing immediate income through the premiums paid by the call buyers.
- Lock In Profits. The writer of the call option sets the strike price. As long as you set a strike price that’s profitable for you, if you are forced to sell your shares after selling covered call options, you’ll be selling for a profit.
Cons of Covered Calls
Although there are clear benefits to selling call options, there are also some disadvantages that should be seriously considered before getting involved:
- Limited Profit Potential. Covered calls limit your profit potential if a stock price rises too high. That’s why it’s best to only sell covered calls on stocks you believe will fall, remain flat, or experience minimal upward movement in the near term.
- Your Brokerage Must Approve You for Options Trading. Options trading is inherently risky, and therefore is not available to all investors. In most cases, you’ll have to ask your broker to approve your account for options trading. Your approval will depend on a mix of your market knowledge, portfolio size, and market performance. Beginners will likely experience hurdles when attempting to access options.
- False Sense of Security. Although the options premium does provide a buffer against downside risk, it can also make you too comfortable with losses in the underlying stocks. Even with a covered call in place, you’ll still lose money if the price of the underlying stock you own drops significantly. Stick to your strategy and stop the bleeding if the underlying stock begins to move too far down.
Should You Consider a Covered Call Strategy?
Options trading is not for everyone, but if you do it, a covered call strategy might be just what you need to take your investments to the next level. But, as mentioned above, there are a few drawbacks. When deciding whether you’re going to sell covered calls for a specific stock you’re holding, consider the following:
- For the Moderately Bullish. A covered call strategy is best if you expect only minimal movement from the underlying stock. If you expect significant growth, avoid writing these options because you could lock yourself out of much of the upside. If you expect significant declines, you might be better off selling the stock outright.
- Don’t Become Blind. Even if you have a covered call in place, it’s important to keep your stop losses intact. If a stock falls too far, there’s no guarantee it will recover. Having an open covered call position isn’t an adequate reason to accept losses below what your strategy allows in the first place.
Frequently Asked Questions (FAQs)
As with any other popular investment strategy, there’s a long list of commonly asked questions about the covered call option strategy. Here are the answers you’re likely looking for:
What Does It Mean to Cover a Call Option?
Covering a call simply means that the seller of the option owns the underlying security associated with the contract. The seller is “covered” if the price of the stock reaches the strike price and will not have to buy more expensive shares in the open market.
Can You Lose Money on a Covered Call?
Money can be lost with any trade you consider making in the stock market. In the case of a covered call, if the price of the underlying asset falls below the price you paid to own it plus the premium you were paid on the call, you’re losing money.
For instance, using the example above, John paid $20 per share to own the stock, $0.01 per share to write the contract, and accepted a premium of $0.75 per share. So, on the downside, if the stock were to fall below $19.26 ($20 – $0.75 + $0.01), John would be losing money on the position.
What’s the Difference Between a Covered Call and a Call?
When the seller of a call option also owns 100 shares of the underlying security, the transaction is considered a covered call.
If the writer doesn’t own the shares of the underlying stock, the option is a traditional call option. If assigned, the seller must buy shares in the open market at the current price to fulfill the contract.
What’s the Potential Profit of a Covered Call?
The best case scenario for the call writer is that the stock never reaches the strike price, leaving the premium paid (minus fees) as profit.
In John’s example above, the best possible outcome would be that he would keep the $75 premium paid per contract, minus $1 per contract in brokerage fees, for a total of $74 per contract. Considering all 10 contracts, in the best case scenario, John would net $740 and keep all his shares.
What’s the Time Horizon for a Covered Call?
Expiration dates on options can range wildly from contract to contract. When writing the call, your best bet is to stay in the 30- to 45-day range. Pushing the expiration out too far adds to the risk of the underlying asset reaching the strike price. Setting the expiration date too close severely limits the amount of premium you can collect.
Covered calls are a great way to earn income on stocks you already own and believe will likely move slowly ahead. However, like any other investment, these derivatives aren’t perfect. There’s always the potential for losses.
As such, when writing calls, it’s important to do your research and make sure there are no major catalysts ahead that have the potential to lead to significant growth in share prices. Also, keep an eye on potential declines because the premium offered through writing calls only offers minimal protection.