Covered Calls Explained (Simply)

Last updated on September 20, 2023

➀ What is a covered call?

Covered calls are an options strategy where an investor combines a long stock position with a short call option, aiming to generate income from their stock holdings while reducing the cost basis of the position.

This strategy provides a bridge between stock investing and options trading, offering opportunities for income generation.

What is a covered call: 8 key Takeaways
1. Selling Covered Calls
Consider selling covered calls when you have a moderately bullish view on your stock holdings. This strategy generates income and lowers your cost basis.
2. Strike Price Selection
When choosing a strike price for your call option, opt for out-of-the-money options. While these provide less credit, they have a lower chance of being exercised.
3. Ownership Requirement
Ensure you own at least 100 shares of the underlying stock to sell a covered call.
4. Defining Profit Potential
Understand that covered calls come with a capped profit potential, which is limited to the premium received from selling the call option.
5. Managing Risk
Although covered calls limit risk, be aware that there’s no predefined maximum loss. Monitor your position closely, especially if the stock drops significantly.
6. Volatility Consideration
Keep an eye on implied volatility. Covered calls work best when volatility decreases, as this can lower the risk of the stock being called away.
7. Time Decay Advantage
Leverage time decay (theta) to your advantage. Covered calls benefit from the passage of time, with the option’s value decreasing as expiration approaches.
8. Exit Strategies
Have exit strategies in place based on the stock’s price relative to the strike price. If the stock remains below the strike, consider rolling the option or selling a new one. If the stock exceeds the strike, be prepared to sell the shares.

Covered call basics

Covered calls offer a way to merge stock ownership and options. To execute a covered call, an investor must hold at least 100 shares of the underlying asset because each option contract corresponds to 100 shares of stock.

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You can either own the shares before selling the covered call or simultaneously purchase the shares and sell the call.

When to use covered calls

Covered calls are a favorable strategy for moderately bullish investors planning to maintain their stock positions over an extended period. This strategy helps generate income during the holding period and effectively lowers the original position’s cost basis.

How to set up a covered call

Setting up a covered call involves selling a call option against your long stock position. Typically, the call is sold out-of-the-money, above the current stock price. Selling closer-to-the-money calls yields more credit but comes with a higher risk of being in-the-money at expiration.

While covered calls don’t eliminate downside risk, each one adds credit to your account, reducing the overall cost of holding the long stock position.

➀ Covered calls payoff diagram

Selling a covered call limits profit potential but doesn’t eliminate downside risk. It does, however, reduce risk by the premium amount received. For instance, if you buy a stock at $100 and sell a $105 strike call for $5.00, your cost basis becomes $95.00.

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If the stock drops below this price, the downside risk remains, but any drop below $95.00 becomes your responsibility. If the short call is in-the-money at expiration and assigned, your profit is limited to the option’s strike price plus the premium received, and you must sell your shares at the short strike price.

what is a covered call example

How to enter & exit covered calls

To initiate a covered call, you need to own at least 100 shares of stock. If you already own the stock, you can sell a call option at a higher strike price. Alternatively, you can sell a call when purchasing the stock.

Exiting a covered call at expiration depends on the stock’s price relative to the call’s strike price. If the stock is below the strike, the call expires worthless, and you keep the premium. If the stock is above the strike, your stock may be called away, or you can roll the position to a later expiration date.

Time Decay & Implied Volatility

Time decay and implied volatility impact covered calls. Time decay affects extrinsic value, with longer-dated expirations collecting more premium.

Implied volatility influences prices, and higher implied volatility results in higher call prices. Covered call writers benefit from time decay (theta) working in their favor.

How to adjust a covered call

Covered calls can be adjusted based on changes in the underlying asset’s price. If the stock rises above the call’s strike, you can choose to roll the position. If the stock moves sideways or down, the original call may expire worthless, allowing you to open a new position for a future expiration date.

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How to hedge a covered call

Hedging involves rolling down the short call as the stock price decreases. Additionally, purchasing a long put option below the short call’s strike can provide protection. However, buying the put option offsets some of the credit from selling the covered call.

What is a synthetic covered call?

A synthetic covered call combines owning deep in-the-money call options (LEAPS) with selling short-term call options against the position. This strategy reduces the capital outlay for stock exposure while continuously receiving credit by selling short-term calls.

The maximum risk in this trade is limited to the cost of the long call option, decreasing each month with the premium collected from call sales.

➀ Covered Calls FAQ

What is a covered call?

A covered call is a popular options strategy employed for income generation. It involves selling a call option against a portfolio of long stock shares. This strategy is well-suited for moderately bullish investors who plan to retain their stock holdings for an extended period.

By selling a covered call, you receive a premium during your holding period, effectively reducing the original cost basis of your equity position.

How do covered calls work?

A covered call strategy entails selling a call option against a portfolio of long stock holdings. Typically, these calls are sold out-of-the-money, above the current price of the underlying asset.

Calls sold closer to the stock’s current price yield more credit but carry a higher risk of ending up in-the-money at expiration.

To execute a covered call, you must own at least 100 shares of stock. The shares act as collateral when selling the short call, bringing in a credit that lowers the overall cost basis of your position. If the covered call expires out-of-the-money, you retain the full premium received from the call sale.

In contrast, if it expires in-the-money, the call is automatically assigned at expiration, obliging you to sell your shares at the strike price.

What is an example of a covered call?

To implement a covered call, you must own a minimum of 100 shares of stock. You can either sell a call with a strike price higher than your current stock price if you already own the shares, or you can sell a covered call at the time of purchasing the long stock position.

For instance, if you own 100 shares of AAPL stock at $150 per share, you can opt to sell a covered call with a $150 strike price.

What is the risk of covered calls?

While covered calls effectively reduce the cost basis of your stock position, they do not eliminate downside risk.

If your call option expires in-the-money, you are obliged to accept assignment, resulting in the sale of your stock shares at the strike price. However, you can choose to roll an in-the-money covered call to a later expiration date if you prefer not to sell the shares.

What is the best way to sell covered calls?

When selling covered calls, several factors should be considered. Calls sold closer to the stock price yield higher credit but carry a higher likelihood of ending up in-the-money at expiration.

Additionally, calls with longer time until expiration come with larger premiums. Your choice should align with your risk tolerance and market outlook.

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