Selling Covered Calls: Why & When?

Why and when might you use the covered call strategy?

The covered call strategy involves buying stock and selling call options on a share-for-share basis.

For example, a covered call position can be created by selling 1 XYZ Callwith a strike price of $50 that expires in April at a price of $1.60 per share and owning 100 shares of XYZ stock at $48.50 per share.

The profit and loss diagram shown here illustrates the important aspects of the covered call strategy.

The profit potential of a covered call is limited.

If the stock price is above the strike price of the call at expiration, then an assignment notice will be received and the stock will be sold. The call premium will be kept as income. Be aware that assignment of short calls can happen at any time prior to expiration. If the stock price is above the strike price at expiration, the result will be the same profit, regardless of the stock price.

If the stock price is below the strike price at expiration, the call expires worthless, and the stock position is kept. The profit or loss at expiration is determined by the relationship of the stock price to the break-even point. Below the break-even point, losses increase as the stock price falls.

The covered call strategy can help investors achieve two different goals.

First, covered calls can be used to help investors who want to sell a particular stock in their portfolio.

Second, covered calls can be used by income-oriented investors or anyone who has part of a portfolio devoted to income-oriented investments.

For investors who want to sell a particular stock, a covered call establishes an effective selling price for the stock. The effective selling price equals the call price plus the strike price. If an assignment notice is received, then the stock is sold at this effective price.

If a call expires worthless, the stock is not sold. However, the call premium is kept as income. Once an option expires, the investor is then able to open a new covered call position in their account.

For income-oriented investors, call premiums can offer increased potential return on the stock investment.

In some cases, the call premium received is higher than the dividends paid by the stock.

Call premiums also offset, to a limited extent, the potential loss of declining stock prices.

let's take a moment to consider the potential returns from covered calls. In our hypothetical example, we owned XYZ stock at $48.50 per share and sold an April call with a strike price of $50. In this example, let's assume this option was 90 days from expiration and the price of the call was $1.60 per share.

$1.60 is approximately 3 percent of $48.50, for a 90-day period. The level of call premiums depends on the characteristics of individual stocks and general market conditions. Furthermore, there is no guarantee that any level of premium can be repeated every 90 days. Nevertheless, the potential income that can be generated by selling covered calls can be attractive to many investors.

Investors who want to sell stock might consider selling covered calls when the target selling price for the stock is above the current stock price.

Covered calls are an income-generating alternative to using a limit-price sell order.

The premium received for selling covered calls offers limited downside protection for the stock, and this may be another attractive feature for investors who have stock they want to sell.

Since income-oriented investors have different goals than investors who want to sell stock, they need a different set of market conditions to justify the use of covered calls.

First, the forecast should be for sideways stock price action where the stock is expected to trade within a relatively narrow range.

Second, if the stock price rises more than anticipated, a decision is required. Whether the decision is to buy back a short call or to let the stock be called away, income-oriented investors must be willing to manage this obligation and understand there is a risk of losing money if you decide to close the position by buying back the call.

Upside price action is not the only potential problem with making stock price forecasts. Covered call writers must also make a decision if a stock falls more than anticipated. Will they continue to hold the stock or sell even if this means taking a loss on the investment. If they decide to sell prior to expiration, they must first buy the call back to close the position.

Finally, investors who use the covered call strategy must make a subjective decision as to whether the potential income from selling covered calls is high enough to justify the time commitment and the risk. Again, this is a subjective, personal decision that investors must make for themselves.

To learn how to place covered call orders in your account, click on the How To tab in this module.