Introduction

You have heard “covered call” strategies mentioned on several occasions and are curious if this strategy could benefit you. You learn that there are three primary reasons why a market participant might select a covered call strategy:

(1) To collect cash income when the forecast is for neutral-to-bullish price action in a stock.

(2) To sell a stock holding at a price that is above the current market price.

(3) To get a small amount of downside protection if the stock price declines.

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What is a Covered Call?

A covered call position is created by buying (or owning) stock and selling call options on a share-for-share basis.

The call premium collected provides an investor with some income in unchanged markets and limited protection in declining markets. In exchange for this premium though, the investor gives up profit potential for stock moves above the strike price of the call. The risk in a covered call strategy exists on the downside due to the stock position held and the potential for a sharp decline in stock price.

In neutral markets, the call premium generates income for the seller. With this, the seller of a call assumes the obligation of selling the stock at the strike price at any time until the expiration date.

Worth noting: The “covered call” strategy is known by different names which have slightly different meanings.

• “Buy-write” implies that stock is purchased and calls are sold at the same time.
• “Over write” implies that stock was purchased previously and that calls are being sold against an existing stock position.
• “Covered call” simply describes a short call position against which stock is owned and does not imply anything about the timing of the stock purchase relative to the sale of the call.

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Example

Assume stock XYZ is trading at $100

• Sell 10 XYZ 105 calls for $1.45
• Buy 1000 XYZ shares

Outcome 1: Profit

The potential profit of a covered call position is limited to the call premium received plus the strike price minus stock price less commissions and fees.

In the example above:

• Call premium is $1.45 per share
• Strike price - stock price = $105 – $100 = $5 per share.

The maximum profit, therefore, is $6.45 per share less commissions and fees. It is realized if the call is assigned and the stock is sold. Note, calls are generally assigned at expiration when the stock price is above the strike price. However, there is also a possibility of early assignment.

Profit = Net Premium Received

Maximum Profit = Net Premium Received + Strike Price – Stock Price

Example

Stock XYZ is trading at $100 and you establish a covered call position:

• Sell 10 XYZ 105 calls for $1.45
• Buy 1000 XYZ shares

A week later, stock XYZ is trading higher at $110.

Recall our equations for the profit/loss of an individual call option (S represents current stock price, and K represents strike price):

If S – K > 0,

Long Call Profit = Current Stock Price – Strike Price – Net Premium Paid

Short Call Loss = – (Current Stock Price – Strike Price – Net Premium Received)

If S – K < 0,

Short Call Profit = Net Premium Received

Long Call Loss = Net Premium Paid

*Unrealized profits are those that potentially exist; realized profits occur when you close out or trade out of the position.

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Outcome 2: Loss

With a covered call strategy, you are exposed to substantial risk if the stock price declines below the breakeven price of the position.

Example

Stock XYZ is trading at $100 and you establish a covered call position:

• Sell 10 XYZ 105 calls for $1.45
• Buy 1000 XYZ shares

A week later, stock XYZ is trading lower at $90.

Recall our equations for the profit/loss of an individual call option (S represents current stock price, and K represents strike price):

If S – K > 0,

Long Call Profit = Current Stock Price – Strike Price – Net Premium Paid

Short Call Loss = – (Current Stock Price – Strike Price – Net Premium Received)

If S – K < 0,

Short Call Profit = Net Premium Received

Long Call Loss = Net Premium Paid

*Unrealized profits/losses are those that potentially exist; realized profits/losses occur when you close out or trade out of the position.

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Outcome 3: Breakeven

The breakeven price for a covered call strategy equals the Stock price minus net call premium received.

In our example, the breakeven stock price equals $98.55 ($100 – $1.45 = $98.55) not including fees and commissions.

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At-A-Glance

Strategy

• Covered Call

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Alternative Name

• Buy Write

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Pre-Requisite Strategy Knowledge

• Long Stock
• Short Call
• Short Put

Legs of Trade

• 1

Sentiment

• Bullish, Neutral

Example

• Short 10 XYZ 105 calls
• Long 1000 XYZ for $100

Rule to Remember

• Long stock and short calls on the same stock

Max Potential Profit (GAIN)

• Limited: Net Premium Received + Strike Price – Stock Price

Break-Even Point

• The breakeven point occurs when XYZ stock price is trading equal to the stock price minus net premium received.

Max Potential Risk (LOSS)

• Stock purchase price – net premium received

Ideal Outcome

• XYZ price trades at or above the strike price

Margin Requirement

• No

Early Assignment Risk

Equity options in the United States can be exercised on any business day, and the holder of a short options position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment must be considered when entering positions involving short options. Early assignment of options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned.

The short call has early assignment risk.

• If the stock price is above the strike price of the short call, a decision must be made if early assignment is likely. If you believe assignment is likely and you do not want a short stock position, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated by: (1) Purchasing the call option to close out your short call position.

Calls are automatically exercised at expiration if they are one cent ($0.01) in the money. If early assignment of a short call occurs, stock is sold at the strike price of the call.

• If you do not own the stock that is to be delivered, then a short stock position is created. If you do not want a short stock position, you can close it out by buying stock in the marketplace.

Important consideration: Assignment of a short call might also trigger a margin call if there is not sufficient account equity to support the short stock position.

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