Covered Calls
What are covered calls?
A covered call is an options trading strategy that involves holding a long position in a stock and selling call options on that stock (buy stock, sell calls). This strategy is typically employed to generate additional income from your stock holdings. This is primarily used when you expect the stock to remain fairly flat.
Covered calls are often thought of as a risk-free way to earn money, however, this isn't entirely true. No gains ever come without risk—with covered calls there is opportunity cost risk, as well as the possibility of risk mismanagement. We'll discuss these below.
How-To
A covered call is made by selling 1 call per 100 shares of stock owned. When you sell a call option you are giving the buyer the right, but not the obligation, to buy 100 shares of stock from you at the strike price. As the seller it is your obligation to sell those 100 shares to the buyer if they exercise that right. This is why the trade is called a covered call—you already own the 100 shares that you would have to sell to the option buyer. Your short call is covered.
Example of a covered call: You own 300 shares of Apple stock which is trading at $193. You sell 3 $200 calls expiring in one month and collect $5.00 per option, for a total premium collected of $1,500.
Purpose
1. Income Generation - The primary purpose of covered calls is to earn income through the premiums received from selling the call options.
2. Portfolio Management - It can be used as a tool for managing portfolio risks and returns, especially in sideways or slightly bullish markets.
3. Downside Protection - The premium received provides limited protection against a decline in the stock's price.
Risks
1. Limited Upside - If the stock price rises significantly, the seller misses out on gains above the strike price of the call option. This is opportunity cost risk.
2. Stock Ownership Risk - The strategy involves owning the underlying stock, which carries the inherent risks of stock ownership, including the possibility of the stock price falling. Covered calls can provide investors a false sense of downside protection.
3. Assignment Risk - There is a risk of the option being exercised (assigned), requiring the seller to deliver the stock at the strike price, which might be lower than the current market price. This risk can be both an opportunity cost risk and a tax risk.
Rewards
1. Premium Income - The immediate reward is the premium (income) received from selling the call option.
2. Profit Potential - If the stock price stays below the strike price, the seller keeps the premium and the stock, allowing for potential additional gains from stock appreciation and dividends.
3. Flexibility - Covered calls can be written for different time frames and strike prices, offering flexibility to the investor.
Example
Let's say you own 100 shares of the Acme Widgets Company (AWC), currently trading at $50 per share. You believe the company is a good one and will continue to go up, but it isn't exactly a high-flying stock and you think the stock price will rise slowly or may even stagnate for a while. In order to try and improve your gains from the stock, you sell 1 covered call option with a strike price of $55 and a one-month expiration, receiving a premium of $2 per share ($200 total).
Let's look at three possible outcomes of this strategy:
- In one month AWC stock has fallen to $45 - The call option expires worthless (out-of-the-money), you keep the $200 premium you originally received for the option as well as your 100 shares. During that month the stock fell $5.00, meaning the value of your stock has fallen $500, however, you received $200 for the covered call, reducing that loss to $300. Meanwhile, you still own the stock and it is possible it will recover later.
- AWC doesn't move and is still sitting at $50 one month later. While the gain/loss from the stock is $0, you have made $200 from the covered call that has expired worthless (out-of-the-money, below the strike price). You still own the stock, and could choose to trade covered calls again.
- AWC creates a widget that goes viral on Tik-Tok and sales propel the stock to $80. This is where opportunity cost rears its ugly head. In this case your stock would have gained $3,000 (100 x $30), but the covered call would have lost $2,300 ($80 stock price - $55 strike price + $2 premium received). Your net gain is $700, instead of the $3,000 you would have gained if you had not traded the covered call. In addition, the call is in-the-money and is therefore exercised by the buyer of the call, meaning that you are obligated to sell your 100 shares of stock at $55. In this case you limited your gains, and lost your stock (which may result in higher short-term capital gains tax if you ended up holding it less than one year). There is a way to avoid losing control of your stock, but that requires buying the call option back before expiration at a significant loss, at which point you will still own the stock but locked in an option loss while leaving yourself exposed to the risk of the stock price falling again.
Here's a chart showing how this works across varying stock prices and assuming you hold the option until expiration.
- Long 100 shares of Acme Widget Company stock at $50/share
- Selling a $55 call option for a premium of $2.00
- The x-axis represents the stock price at expiration
- The y-axis shows the profit or loss of the strategy in dollars
The blue dashed line indicates the initial stock price ($50), and the green dashed line marks the strike price ($55) of the short call option. The chart illustrates how the profit or loss changes with the stock price at expiration.
When you owned only 100 shares of stock at $50, that was your break-even price. You'd make money as the stock went higher and lose money as the stock went lower.
After selling the call and collecting $2.00 your break-even price drops down to $48. Below $48 you will simply lose the amount of the 100 shares of stock and the short call will have no more effect.
Now, above $50 you will still make more money, but now your max profit will be capped at the $55 level. Above that level you will make $100 for every $1 the stock goes up, but you will also lose $100 on the short call, so the two will wash each other out.
So, you can see that the covered call position has provided you $2.00 in income, but it comes with the risk of capping your gains. As an example, if the stock were suddenly bought out by a larger company for $100, your profits would be capped at $55 instead of getting the full advantage of the buyout price.
Conclusion
Covered calls can provide a nice additional benefit, especially to long-term buy-and-hold stock positions. They are suitable for stocks that you are bullish on, but that you don't feel should expect explosive growth any time soon.
They are a low-risk trade strategy to provide income from a stock that you own. This can add significantly to gains over time.
The risk comes in the form of the missed opportunity, should the stock price shoot past the strike price of the short call position. This also creates the additional risk of the call being exercised and your shares being closed out, creating a taxable capital gain or loss on the shares.
Additionally, covered calls can create the sense of downside stock price protection. While this is true to some degree (the amount of premium received from the call option), it is limited and shouldn't replace normal risk management of a trade or investment.
While they are a self-limiting position that doesn't require much oversight once initiated, they will require trade management if the stock moves above your strike price. In that case you will need to decide whether to allow the option to be exercised and take away your stock position, whether to close the option for a loss before expiration and maintain your stock, or whether to roll the option to a different strike and expiration (essentially locking in the current option's loss, while initiating a new covered call position).
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