Covered calls are one of the most popular options-based strategies in the stock market because they provide equity holders with valuable flexibility when it comes to managing positional risks and rewards.
Although trading options may not fit every investor’s risk profile, the covered call is a straightforward and effective strategy that many market participants utilize to boost returns.
Most investors are keenly aware of the difference between stocks and bonds.
- Stocks (i.e. equities) involve taking ownership in a company
- Bonds represent the debt of a company and act much more like an IOU
As their name implies, equity options (aka derivatives) afford equity investors and traders with a wider range of choices for expressing their market opinion, or managing their positions. There are two categories of equity options—calls and puts.
Calls provide the owner with the right, but not the obligation, to buy stock at a specific price for a set period of time. Puts provide the owner with the right, but not the obligation, to sell a stock at a specific price for a set period of time.
Options can be used in conjunction with an underlying stock position or traded on their own. It’s important to note that only a select group of public companies have exchange traded options—approximately 3,000 companies.
Covered Call Strategy Overview
There are a myriad of ways that options can be deployed in a portfolio for the purpose of speculation, risk mitigation, or hedging.
Investors that want additional upside exposure can purchase calls, whereas holders of concentrated stock positions that want to protect their position from downside exposure can purchase puts.
Beyond these more simplified strategies, there’s a slightly more complex method of utilizing options that has carved out a fairly significant niche in the financial markets—a strategy as the “covered call.”
A covered call position entails getting long a stock while also selling a call option against it.
Under this structure, the investor/trader is now a seller (or “writer”) of the option. For calls, that means the seller has the opposite position of a long call holder. The writer has sold the right for someone else to buy stock at a specific price over a set period of time.
When a call buyer decides to execute their right this is called an “exercise.” The call owner has “exercised” their right to buy the underlying stock.
For owners of stock that have a specific target in mind where they would like to sell a particular stock, a covered call can be an excellent strategy to deploy in the portfolio.
Additionally, for stock owners that expect the position to trade sideways or sit still, a covered call can also help boost returns during periods when the stock might theoretically produce diminished returns.
Covered Call Strategy, Hypothetical Example
A comprehensive example of the covered call strategy should help better illustrate the mechanics of this position, and the associated potential risks and rewards.
Imagine an investor owns 5,000 shares of hypothetical stock ABC, and is interested in deploying a covered call strategy. The investor wants to limit his/her exposure to only 1,000 of the 5,000 shares, which would equate to 10 calls, because each call contract represents 100 shares (10 call contracts x 100 shares/contract = 1,000 shares).
Now imagine that stock ABC is trading for $20.00/share and the investor holding 5,000 long shares decides to sell 10 of the $22.50 strike calls for $0.50. Each option contract accounts for 100 shares, so 10 contracts therefore represents 1,000 total shares (10 x 100 = 1,000). Assume the investor purchased the 5,000 long shares at a price of $20/share.
The total premium collected from the call sale is equal to the number of contracts multiplied times the price of the option multiplied times the option multiplier, or 10 x $0.50 x 100 = $500. Now we can look at the potential P/L from this position based on three different scenarios.
Scenario 1: ABC is trading $18/share at expiration. The investor owns 5,000 shares of ABC, and the stock has dropped from $20/share to $18/share, so the investor loses $2 x 5,000 = $10,000 on the stock position. At this price, the short calls expire worthless, so the investor gets to keep the $500 of premium from the option sale. The option premium therefore offsets some of the losses, and instead of losing $10,000, the investor loses only $9,500 ($10,000 – $500 = $9,500).
Scenario 2: ABC is trading $20/share at expiration. The investor owns 5,000 shares of ABC, and the stock is trading for the same price at which it was purchased. The investor has therefore broken even on the stock position. At this price, the short calls expire worthless, so the investor gets to keep the $500 of premium from the option sale. The investor has therefore made an extra $500 in profit, instead of only breaking even from holding the stock.
Scenario 3: ABC is trading $25/share at expiration. The investor owns 5,000 shares of ABC, and the stock has increased from $20/share to $25/share. In this case, 4,000 shares are naked long, and 1,000 shares are part of the covered call, an important distinction in this scenario. Regarding the naked long 4,000 shares, the investor has made $5/share, which is equal to $20,000 ($5 x 4,000 = $20,000). In the case of the covered call, the investor participates in the gains of owning 1,000 shares from the purchase price ($20) to the short strike of the covered call ($22.50), which equates to $2,500 ($2.50 x 1,000 = $2,500).
However, the underlying has moved beyond the strike price, so the investors shares are “called” away above $22.50, which means he/she misses out on the gains in 1,000 shares of stock from $22.50 to $25.00. The investor also gets to keep the premium from the sale of the short calls, which adds another $500 to the profit of the position. The total profit is therefore $20,000 + $2,500 + $500 = $23,000. Had the investor held all 5,000 shares long, and not written the covered call, his/her profit would have been $25,000 ($5/share x 5,000 = $25,000).
As one can see in the scenarios above, the covered call strategy can be a great way for investors to enhance bullish positions, especially during periods in which the stock is expected to trade sideways, or sit still.
In such cases—as outlined in the first two scenarios above —the premium collected from the short calls helped to boost net P/L.
In the third scenario, the investor could have obviously made more money by staying long all 5,000 shares of stock, and skipping the covered call all together. But the overall return of the third approach didn’t suffer extensively by writing a covered call on a small portion of the stock holdings.
As with every options strategy, the utilization of the covered call approach is therefore dependent on a given investor’s unique outlook and risk profile. One can also see how a covered call approach might be more attractive if an investor feels option premiums are too high (i.e. Implied Volatility Rank > 50%).
Readers seeking to learn more about the covered call strategy can review a new episode of Best Practices on the tastytrade financial network when timing allows. To learn more about Implied Volatility Rank (aka IV Rank) in the current trading environment, this episode of Tasty Extras is also recommended.
Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to firstname.lastname@example.org.