The bulls have been in charge to start the 2023 trading year, but there’s no telling where the stock market trades from here. 

That means bullish investors and traders that bought the dip last year have several choices available to them at this time. One of those is to convert their existing long positions into covered calls. 

Investors and traders generally deploy covered call positions when they are bullish but expect the underlying to trade sideways for the foreseeable future. That means a covered call could be just the ticket for investors and traders who think that the rally in the stock market (or an individual stock) has run out of steam. 

The great thing about a covered call is that these positions can still offer upside potential However, covered calls can also be beneficial when the underlying trades sideways, or lower, during the life of the option.

Looking at a specific example, imagine a bullish market participant purchased Tesla (TSLA) stock last year during the broader market correction. Imagine a hypothetical investor bought 100 shares of Tesla for $140.00/share in December of 2022.

As of mid-February, Tesla shares are currently trading roughly $215/share. That means the trader is up roughly $7,500 on the position ($21,500 – $14,000 = $7,500).

At this juncture, the investor may elect to close the position for a profit, close a part of the position for a profit, or let the position ride for a while longer. The exact decision taken will depend on the investor’s outlook for Tesla, and possibly the broader market. 

However, an investor may also elect to convert a pure long stock position into a covered call. Covered calls are built using a long position in the underlying and a short call position in the same underlying.

Using the aforementioned Tesla example, an investor would simply sell a call against his or her long stock to create a covered call position. 

In order to be considered a covered call, the investor/trader needs to own at least as much stock as they’ve put at risk in their short calls. For example, a trader selling 1 call contract would need to own at least 100 shares of the underlying, because each equity option contract represents 100 shares of the underlying stock/ETF. 

As stated previously, a covered call can be a good choice when one expects the underlying to trade sideways during the life of the option. If that occurs, the investor gets to maintain his or her long stock position, while also collecting the premium from the short call option. 

The worst outcome for a covered call is a significant drop in the value of the underlying. But in that scenario, the losses are generated by the long stock position, not the short call. The covered call position has a similar downside risk profile as the naked long stock position.

Circling back to the Tesla example, imagine the hypothetical investor elects to sell 1 call contract against his or her long 100 TSLA shares. With the stock currently trading $215/share, the investor elects to sell an April call in Tesla with a strike price of $225 that is trading for $20.00. 

That means the investor receives $2,000 in premium ($20 x 1 contract x 100 option multiplier = $2,000). Now it’s possible to evaluate the performance of the position across several different scenarios.

Scenario 1: Tesla stock is trading $215/share at expiration

Under this scenario, the investor only makes a profit on the short call position, because the underlying stock is trading at the same level it was trading when the short call position was established. The long stock position doesn’t win or lose, it breaks even. However, the short $225-strike call expires worthless, which means the investor gets to keep the entire $2,000 in premium from the sale of the call. 

Net Profit = $2,000

Scenario 2: Tesla stock is trading $200/share at expiration

Under this scenario, the investor loses money on the long stock position, but makes a profit on the short call position. In the case of the long stock position, the stock has dropped in value from $215/share to $200/share, so the investor loses $1,500 (100 shares x $15 = $1,500). Fortunately, the short $225-strike call expires worthless, which means the investor gets to keep the entire $2,000 in premium from the sale of the call.

Net Profit = $500

Scenario 3: Tesla stock is trading $250/share at expiration

Under this scenario, the investor makes money on both the underlying stock position and the short call position, but gives up some upside in the stock position. Additionally, his or her long shares get called away. In the case of the long stock position, the stock has increased in value from $215/share to $250/share, but the investor only participates on the upside to $225, because that’s the strike price of the short call. So, the investor makes $1,000 on the long stock position (100 shares x $10 = $1,000). The investor also gets to keep the $2,000 in premium from the sale of the call.

Net Profit = $3,000

The three scenarios outlined above help illustrate the potential benefits and drawbacks of a covered call position. Depending on one’s outlook for Tesla stock, and the broader stock market, the covered call may or may not fit one’s investment/trading objectives at this time. 

Looking broadly at covered calls and hypothetical trading scenarios, these positions perform well when the underlying settles right at the short strike, and the underlying stock isn’t called away. 

On the other hand, the worst outcome for a covered call is a sharp correction in the underlying. But in that scenario, the losses are generated from the long stock position, not the short call position. The short call premium actually helps offset the losses from the stock position in that situation. 

An important consideration when trading covered calls is that they can theoretically limit upside gains. For this reason, many market participants prefer to deploy covered calls when they expect the underlying to trade in range-bound fashion. 

Investors and traders holding large, concentrated stock positions may also elect to sell covered calls on a small portion of their stock, as opposed to the entire holding.

For example, an investor with 5,000 shares of long stock might consider selling 1, 5, or 10 covered calls against the position, which would equate to 100, 500 and 1,000 shares, respectively.

At this time, it’s possible the covered call doesn’t fit your outlook and risk profile, but there may be a point in the future when it does. The most important takeaway is that the covered call strategy provides investors and traders with added flexibility in their positioning. 

For more context on the covered call approach—especially as it compares to a naked long stock position—check out this installment of Market Measures on the tastylive financial network. 

To follow everything moving the markets on a daily basis, monitor tastylive, weekdays from 7 a.m. to 4 p.m. CDT.

Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastylive or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to support@luckboxmagazine.com.