What is a Covered Call?
Covered calls are a popular options strategy for investors who want to generate income and limit their risk. They are a relatively easy strategy to understand and implement, and they can be a good way to get started with options trading.
A covered call is an options strategy that involves selling a call option on a stock that you already own. You would need 100 shares of a stock to sell for each covered call. By owning the stock, you are “covered” (i.e. protected) if the stock rises and the call option expires in the money. Covered calls are one of the lower-risk option strategies, and are suitable for beginning options traders.
How a Covered Call Works
To execute a covered call, you must first own 100 shares of the underlying stock. Then, you sell to open (STO) a call option on that stock. The call option gives the buyer the right to buy 100 shares of the stock from you at the strike price on or before the expiration date. If this sounds completely foreign to you, please read here.
Scenario 1: If the stock price is below the strike price at expiration, the option will expire worthless and you will keep the premium you received for selling the option.
Scenario 2: If the stock price is above the strike price at expiration, the buyer will exercise the option and you will be obligated to sell them 100 shares of the stock at the strike price. You will keep the premium you received for selling the option and you will also make a profit on the stock if you sell it for more than you paid for it.
Illustration of Covered Call
Suppose you own 100 shares of Apple stock, which is currently trading at $150 per share. You sell a call option with a strike price of $155 and an expiration date of one month. You receive a premium of $500 for selling the call option.
Profit and loss
Scenario 1: If the stock price is below $155 at expiration, the option will expire worthless and you will keep the $500 premium you received.
Scenario 2: If the stock price is above $155 at expiration, the buyer will exercise the call option and you will be obligated to sell them 100 shares of Apple stock at $155 per share. You will keep the $500 premium you received and you will also make a profit of $500 from selling the stock for $155 per share because your cost basis for the AAPL share is $150 per share.
Maximum profit
The maximum profit you can make from a covered call is the premium you receive for selling the option and in the scenario where the buyer exercise the call option. In this example, the maximum profit is $1000 ($500 from premium and $500 from letting go the shares at $155 per share)
Maximum loss
None as long as you are not prematurely closing the option at a loss before expiration OR selling a call option at a strike price below your stock cost basis. in this example, as long as you are not selling a call option below a strike price of $150
Benefits of Covered Calls
Covered calls offer several benefits, including:
- Income: Covered calls can generate income in the form of the premium you receive when you sell the call option. It can be a good income generation strategy.
- Limited risk: Covered calls limit your risk because you already own the stock. If the stock price goes down, you will only lose money on the stock if the price goes below your purchase price.
- Potential for profit: If the stock price goes up, you will make a profit on the stock and you will also keep the premium you received for selling the call option.
Risks of Covered Calls
Covered calls also have some risks, including:
- Limited gains: If the stock price goes up, your gains will be limited to the premium you received for selling the call option. You will not make any profit on the stock itself beyond the strike price
- Margin requirements: If you are selling a naked call option, you may need to have enough money in your account to cover the purchase of the stock if the option is exercised. WARNING – Please do not sell NAKED option of any kind if you are not familiar with margin. Not convinced? Read this post from Motley Fool.
Conclusion
Covered calls are a low-risk options strategy that can be used to generate income and limit your risk. However, it is important to understand the risks involved before you start using this strategy. It is considered as one of the lowest risk options as long as it is a COVERED call (i.e. no margin!)
Here are some additional tips for using covered calls:
- DO NOT sell a call option on stocks that you are married to! If they are your forever stocks, don’t bother. Last thing you want is stressing out over losing those stocks. The premium is not worth the stress!
- My recommendation is to NOT sell a call option at a strike price under your stock’s cost basis. For example, if the cost basis of your AAPL stock is $150, DO NOT sell at a strike price below $150. This is to avoid stress when the option went into money. At least you are still making profit from the premium even though you are breaking even on the underlying shares. I’ve seen so many questions whether they should close the option at a loss because they chose to sell a call option at a strike price below their stock’s cost basis
Are you ready to roll? Consider using our Web-based Options Selling Scanner/Screener to get started!