A covered call is an options strategy where an investor holds a long position in a stock and sells (writes) call options on the same stock to generate additional income. This strategy is often employed when an investor has a neutral to slightly bullish outlook on the underlying asset. The primary goal is to earn premium income from the sold call option, which can offset potential declines in the stock's value or enhance returns.
In a covered call setup, the investor:
Owns 100 shares of a stock or ETF.
Sells one call option per 100 shares owned, typically at an out-of-the-money (OTM) strike price.
This strategy allows investors to generate potential interim income on long shares but caps profits if the stock price rises above the call's strike price. Investors remain exposed to the downside risk of the long stock position.
The profit and loss (P&L) profile of a covered call strategy is characterized by:
Maximum Profit: Achieved when the stock price rises to the strike price of the sold call option. At this point, the option may be exercised, and the investor sells the stock at the strike price, realizing gains from both the stock's appreciation up to the strike price and the premium received from selling the call.
Break-even Point: Calculated by subtracting the premium received from the purchase price of the stock.
Maximum Loss: Occurs if the stock price falls to zero. The loss is mitigated by the premium received but remains substantial due to the decline in the stock's value.
This strategy provides limited upside potential due to the obligation to sell the stock at the call's strike price if exercised. However, it offers some downside protection equal to the premium received.
The terms "covered call" and "buy-write" are often used interchangeably but refer to slightly different actions:
Covered Call: Involves selling a call option against shares of stock that are already owned.
Buy-Write: Involves buying shares of stock and simultaneously writing (selling) call options against those shares.
Both strategies aim to generate income through the premiums received from selling call options, but the buy-write strategy is executed as a single transaction.
To implement a covered call strategy, an investor needs:
Stock Ownership: At least 100 shares of the underlying stock or ETF per call option sold.
Approval for Options Trading: Authorization from their brokerage to engage in options trading, specifically the ability to sell covered calls.
Margin or Cash Account: Covered calls can be sold in both margin and cash accounts. The buying power requirement is typically the initial and maintenance margin applicable to the long stock position, with no additional requirement for the short call.
Stock Purchase Price: $50 per share
Number of Shares Owned: 100
Call Option Sold: One OTM call option with a strike price of $55, expiring in one month, premium received $2 per share
Stock Loss: Up to $5 per share
Option Premium: $2 per share
Net Loss: Up to $3 per share
Stock Gain: $0 to $5 per share
Option Premium: $2 per share
Total Gain: $2 to $7 per share
Stock Gain: $5 per share
Option Premium: $2 per share
Total Gain: $7 per share (maximum profit)
In this example, the maximum profit of $7 per share is realized if the stock price is at or above $55 at expiration. The premium received provides a buffer against minor declines in the stock's price.
To sell a covered call:
2. Strike Price: Typically above the current stock price (OTM) to allow for some capital appreciation.
Expiration Date: Choose based on income goals and market outlook; shorter expirations provide quicker premium decay.
Order Type: Sell to open one call option contract for every 100 shares owned.
Monitor the Position: Keep track of the stock price relative to the strike price and be prepared for potential assignment if the stock trades above the strike price as expiration approaches.
It's essential to understand the obligations associated with selling call options, including the potential requirement to sell your shares at the strike price if the option is exercised.
The maximum profit is capped because the stock must be sold at the strike price if assigned.
If the stock price rises significantly, the investor misses out on further gains beyond the strike price.
The sold call option loses value over time, benefiting the covered call writer.
If the stock remains below the strike price, the option expires worthless, and the investor keeps the premium.
Downside risk remains: If the stock price drops significantly, the covered call does not fully protect against losses.
The premium received offsets only part of the potential decline in stock value.
If the stock price exceeds the strike price at expiration, the call option will likely be exercised.
This forces the investor to sell the stock at the strike price, realizing a gain but potentially missing further upside.
If the stock price rises near the strike price before expiration, the investor can roll the short call forward by buying it back and selling a new call with a higher strike price and later expiration.
This allows the investor to capture additional premium while keeping the shares.
If the stock price falls significantly, the call option will lose value quickly.
The investor can buy back the short call at a lower price to close the position and potentially sell a new call at a lower strike.
If the stock price remains below the strike price, the call expires worthless, and the investor keeps the full premium.
The investor can then sell another call to generate additional income.
| Strategy | Market Outlook | Maximum Profit | Maximum Loss | Best Used When... |
|---|---|---|---|---|
| Covered Call | Neutral to slightly bullish | Limited (Strike + Premium) | Large (if stock declines significantly) | You want to generate income while holding shares |
| Cash-Secured Put | Bullish | Limited (Premium Received) | Large (if stock drops significantly) | You want to acquire stock at a lower price |
| Collar Strategy | Neutral to bullish | Limited (Strike Price + Premium) | Protected (due to long put) | You want to cap downside risk |
| Protective Put | Bullish, but cautious | Unlimited | Limited (Put Strike - Stock Price) | You want downside protection while holding shares |
Note: The profit/loss values are estimates and can vary based on factors like implied volatility and time decay.
The covered call is one of the most widely used and effective strategies for investors looking to generate passive income while holding stocks. It works best when:
✔ The stock price remains stable or rises slightly, staying below the strike price.
✔ Implied volatility is high, allowing for a larger premium collection.
✔ The investor is comfortable with limited upside potential in exchange for premium income.
Covered calls generate income by selling call options on owned stock.
The trade works best in neutral to slightly bullish conditions, as strong rallies cap profits.
Rolling, closing early, or letting the option expire are ways to manage the trade.
Downside risk remains, and a major decline in the stock price can still lead to losses.
Since this strategy involves stock ownership, it is best suited for investors who want to generate yield while maintaining long equity exposure.