What Is a Covered Call?
A covered call is an options strategy you can use to reduce risk on your long position in an asset by writing call options on the same asset. Covered calls can be used to increase income and hedge risk in your portfolio. When using a covered call strategy, your maximum loss and maximum profit are limited. test
Key Takeaways
- A covered call strategy involves writing call options against a stock the investor owns to generate income and/or hedge risk.
- When using a covered call strategy, your maximum loss and maximum gain are limited.
- Sellers of covered call options are obligated to deliver shares to the purchaser if they decide to exercise the option.
- The maximum loss on a covered call strategy is limited to the price paid for the asset, minus the option premium received.
- The maximum profit on a covered call strategy is limited to the strike price of the short call option, less the purchase price of the underlying stock, plus the premium received.
Basics of a Covered Call Strategy
When selling a call option, you are obligated to deliver shares to the purchaser if they decide to exercise the option. For example, suppose you sell one call option contract with a strike price of $15 for stock XYZ. The call option expires one week from today. If the stock price closes above $15 at the expiration date, you are obligated to deliver shares of XYZ to the buyer of the option.
The seller of a covered call gets paid a premiumin exchange for giving up a portion offuture potential upside.
Pros and Cons of Covered Calls
Pros
Generates additional income on shares you may already be holding in your portfolio.
Creates potential profit on stocks that have been trading sideways.
Secures capital when you sell call options. The cash you receive from optioning the position is yours regardless of whether the option is executed.
Cons
Limits your profit potential should the stock price close above your covered call strike price.
Protects against losses does not guarantee a loss will be avoided. A covered call will only minimize your loss.
Compounds losses if the stock price drops and you want to sell your position. If you need to buy your call options back, this may create further losses.
Determining the Maximum Loss on a Covered Call Strategy
The maximum loss on a covered call strategy is limited to the investor’s stock purchase price minus the premium received for selling the call option.
Covered Call Maximum Loss Formula:
Maximum Loss Per Share = Stock Entry Price - Option Premium Received
For example, let’s say you are long 100 shares of stock in company TUV at a price of $10. You think the stock will rise to $15 in six months and are willing to sell the stock at $12. Assume you sell one TUV call option with a strike price of $12 expiring in six months for $300.
Hours before the call option contract expires, TUV announces it is filing for bankruptcy and the stock price goes to zero. Your maximum uncovered call would have been the entirety of your investment ($1,000). However, since you received a premium of $300 for the call option, your loss is reduced to $700 ($1,000 cost basis - $300 call option premium).
Determining the Maximum Profit on a Covered Call Strategy
The maximum profit on a covered call position is limited to the strike price of the short call option less the purchase price of the underlying stock plus the premium received.
Covered Call Maximum Gain Formula:
Maximum Profit = (Strike Price - Stock Entry Price) + Option Premium Received
Suppose youbuy a stockat $20 and receive a $0.20 option premium from selling a $22 strike price call. You then decide to maintain your position providing the stock price stays below $22 until the options expire. If the stock price increases to $23, your profit on the sale of the stock is limited to $2 as the $22 strike price of the option limits your potential upside, Your maximum profit is $2.20 per contract: $2 ($22 strike price - $20 stock entry price) + $0.20 option premium.
Are Covered Calls More Profitable?
Covered calls are a hedging strategy to reduce investment risk. In exchange for minimized risk, covered calls also minimize potential gains.
What Are the Benefits of Covered Calls?
Covered calls are strategically positioned to minimize the amount of losses an investor may experience. Investors benefit from covered calls by having their potential downside exposure of an investment limited.
How Do You Calculate Maximum Loss on a Covered Call?
The maximum loss per share on a covered call is calculated by subtracting the option premium received from the initial investment in the stock.
