Covered Call Option Strategy

A covered call option strategy is when an investor sells a Call Option while holding the underlying stock position long. Whereas the buyer of a call option receives the *right to buy* the underlying shares if they exercise their option, the seller incurs the *obligation to sell* those same underlying shares, if their short call option is assigned. In a covered call strategy, this obligation is ‘covered’ because the investor holds the long share position in the account, ready to sell if necessary.

Read More: How Do I Get Started with Call Options? 

Investors seeking to generate income utilize a covered call option strategy to collect premiums from the sale of call options. The premium that investors collect from selling call options on top of their existing holdings adds an additional yield to their overall portfolio.

However, selling a covered call can limit the upside profit potential of the stock. By selling a call option, an investor has the obligation to deliver shares to the call option buyer, in the event the option contract is exercised. If the buyer of the option chooses to exercise his option, the seller’s shares can be called away. This means that the investor won’t benefit from any future stock price increases unless he buys the shares back.

If you found this interesting: Buying a Call vs Buying a Stock  

For this reason, this strategy isn’t optimal for strongly bullish investors. If you expect the underlying stock price to rise considerably, it makes more sense for you to buy calls than to sell them. The covered call strategy is best suited to investors who have a neutral to slightly bullish outlook, and don’t anticipate the stock price to rise considerably in the near term. For these investors, the covered call option strategy can be a useful way to increase their returns on existing positions.

The maximum potential loss of a covered call is the entire value of the stock less the premium received from the option sale. A covered call option strategy requires a moderate level of risk tolerance due to the risk of holding the long stock position.

‌

Let’s See an Example

An investor anticipates that stock price of RAWR will go up in the short term but not beyond a certain price. He purchases 100 shares of RAWR at $10. In addition, he sells a call option of RAWR at the $14 strike price with 1 month until the expiration for a premium of $2.

• Long 100 shares of RAWR stock bought at $10
• Sell 1 RAWR call option at the $14 strike price with 1 month until expiration date for a premium of $2

‌

The maximum profit is the difference between the strike price of the option and price at which he purchased the stock plus the premium collected from the option sale. This is calculated as follows:

Maximum Profit per Option = (Strike Price of Option - Stock Purchase Price + Premium) x 100 shares

$600 = ($14- $10 + $2) x 100 shares

‌

The maximum loss is the stock purchase price less the premium received multiplied by 100 shares. This is calculated as follows:

Maximum Loss per Option = (Stock Purchase Price- Premium) x 100 shares

$800 = ($10 - $2) x 100 shares

‌

The breakeven point is the purchase price of the stock less the premium received. This is calculated as follows:

Breakeven Price = (Short Call Option Strike Price - Premium)

$8= $10-$2

‌

The profit and loss of the covered call option strategy until expiration date is depicted in the chart below.

See: Selling a Covered Call on Paper Trading

The chart shows the potential profit and loss on the y-axis versus the corresponding stock price in the x-axis.

If RAWR trades up to $14 and beyond, the investor will make $600, which is made up of $400 from the stock price appreciation plus the $200 from the sale of the call option. Conversely, the maximum potential downside risk is $800. This is comprised of the $1,000 loss if the stock price goes to $0 less the $200 premium made from selling the call.

If the price of RAWR ever exceeds the price of $14 during the life of the option contract, the investor could potentially be assigned and be obligated to sell his 100 shares. While the investor realizes the maximum profit in this situation, the 100 shares are no longer held long. If, however, the price remains between $8 and $14 up until the expiration date, the investor will receive a profit greater than if he had held the stock and not sold the call. In this way investors can make a greater return selling covered calls in a rising bull market.

The potential downside risk is if RAWR ends up below $8 by the time the option expires. In this scenario the investor will be left with a loss. However, the investor offsets a portion of the loss from the stock decline with the premium received from selling the call option.

Like any investment, options are not without risks. But with a covered call all the risk is actually from holding the long stock which may fall in value. With careful research and attention to those risks, you may find that a covered call may fit your investment strategy.

‌

*The tickers are fictitious and are only intended to illustrate examples of complex option strategies.

All prices used in the examples are not representative of actual prices options can be worth at any time.