A covered call position is created by buying (or owning) shares of stock and selling call options using those shares as collateral. There are different ways for investors to use this strategy. Here, we will explain how to generate a stream of incremental income from your existing shares using the covered call strategy.

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Risk and Return Profile

Before diving into the benefits of the covered call strategy, it is essential to understand its mechanics. Explore the risk and return profile in the below example.

Suppose you have 100 shares of ABC stock in your portfolio currently trading at a price of $50. You want to use a covered call strategy on your 100 ABC shares to collect the premium. After some research, you decide to sell one $55 21 Oct 22 Call for a premium of $3.00. Here’s how your portfolio is affected by this strategy at several different stock prices on the expiration date.

If the call is not exercised, you keep the stock and the premium you collected, so the value of this position in your portfolio is calculated by adding the stock value and premium proceeds.

If the call is exercised, you, as the call seller, will deliver shares at the strike price of $55. The position’s value would then be calculated using the Strike Price (the price you receive for the shares) plus the premium (the price you received for selling the contract) times 100 shares (the standard deliverable of an options contract). In this case, the strike of 55 and the premium of 3 add up to $58 per share, meaning the total value of your position is $5800.

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From the data above, we now have a very clear picture of how the sold call works for you:

• If the stock price is below the strike price, the call will expire worthless, and you keep the entire premium. After that, you can repeat the covered call process all over again to produce a cash flow stream as long as the call is not assigned.

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• When the stock price decreases slightly, the covered call provides limited downside protection. Compared to just owning stocks, the premium received brings the breakeven point down, from $50 to $47, reducing risk. It will not effectively hedge against more significant downturns.

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• A covered call can outperform the underlying security as long as the stock price stays below the level of the strike price plus the premium through expiration.

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• The covered call strategy will help increase your portfolio returns on stocks that have slight price increases. However, upside potential is capped. The seller of the call cannot profit more than the amount of the premium received. If the stock price increases to exceed the strike price plus the premium, the opportunity to sell the shares at those higher prices is lost. The higher the stock price, the more opportunity cost incurred.

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These profit and loss scenarios make the covered call a neutral to bullish strategy.

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Performance in Different Markets

Through the above profit/loss analysis, it would be much easier to see the benefits of the strategy in various market environments, for some market environments are more evident than others. The next section discusses how the covered call strategy performs in different scenarios and why.

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Bull Market

A covered call strategy can be helpful when the stock price is rising. The seller can keep the premium as income and profit from stock appreciation, as long as the stock is not increasing so quickly that call options are assigned. If the stock price increases too much or too quickly, the strategy begins to incur an opportunity cost.

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Sideways Market

When stock price trades within a relatively small range, indicating no clear upward or downward trend, a covered call strategy can be a powerful tool to benefit from the time decay effect. The seller can continuously collect the premium from the sold calls as a source of income in the low volatility environment.

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Bear Market

If the stock price decreases slightly, the covered call strategy will provide limited downside protection to your portfolio due to the income generated from selling call options. However, any significant downturn is likely to outweigh the received premium. If you plan to hold the shares even in a bear market, the premium will generate a small gain to offset the falling prices. Overall, the covered call strategy is not optimal for those with a bearish outlook.

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The Bottom Line

A covered call strategy can make a difference in your portfolio, especially if you’re a neutral-to-bullish investor. For those seeking to put their existing stock positions to work, a covered call strategy can be a great way to generate extra income.

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