The covered call strategy is versatile. There are typically three different reasons why an investor might choose this strategy;
- To collect cash income when the forecast is for neutral-to-bullish price action in a stock.
- To sell a stock holding at a price that is above the current market price.
- To get a small amount of downside protection if the stock price declines.
Example of covered call (long stock + short call)
Buy 100 shares XYZ stock at 98.00
Sell 1 XYZ 100 Call at 3.50
A covered call position is created by buying (or owning) stock and selling call options on a share-for-share basis. In the example, 100 shares are purchased (or owned) and one call is sold. In return for the call premium received, which provides income in sideways markets and limited protection in declining markets, the investor is giving up profit potential above the strike price of the call. The call premium increases income in neutral markets, but the seller of a call assumes the obligation of selling the stock at the strike price at any time until the expiration date. In a covered call position, the risk of loss is on the downside. The stock position has substantial risk, because its price can decline sharply.
Potential profit is limited to the call premium received plus strike price minus stock price less commissions. In the example above, the call premium is 3.50 per share, and strike price minus stock price equals 100.00 – 98.00 = 2.00 per share. The maximum profit, therefore, is 5.50 per share less commissions. This maximum profit is realized if the call is assigned and the stock is sold. Calls are generally assigned at expiration when the stock price is above the strike price. However, there is a possibility of early assignment. See below.
Risk is substantial if the stock price declines. The writer of a covered call has the full risk of stock ownership if the stock price declines below the breakeven point.
Breakeven stock price at expiration
Stock price minus call premium received
In this example: 98.00 − 3.50 = 94.50
Profit/Loss diagram and table: covered call
Long 100 shares at 98.00
Short 1 100 Call at 3.50
|Stock Price at Expiration||Long Stock Profit/(Loss) at Expiration||Short 100 Call Profit/(Loss) at Expiration||Covered Call Profit / (Loss) at Expiration|
Appropriate market forecast
The covered call strategy requires a neutral-to-bullish forecast. Writers of covered calls typically forecast that the stock price will not fall below the break-even point before expiration.
Investors typically sell covered calls for one of three reasons:
- Income-oriented investors use covered calls with the goal of enhancing cash returns. In return for the call premium received, which increases income in neutral markets, the investor accepts a limit on upside profit potential. Whether the shares are purchased at the same time a covered call is sold or purchased previously, the investor should believe that the stock price will trade in a neutral-to-bullish range during the life of the call. If the call expires worthless, then a decision has to be made whether (a) to sell another call, (b) to continue holding the stock without selling another call, or (c) to sell the stock and invest the funds elsewhere. If the stock price rises above the strike price of the call, then a decision has to be made whether (a) to let the stock be called away, or (b) to buy the call and close out the obligation. Note that the call price may increase when the stock price rises, and buying back the call can result in a loss. If the stock price declines, then a decision has to be made whether (a) to hold the stock and risk further declines or (b) to close the covered call position, possibly at a loss.
- Investors who have a target selling price for a stock can sell a covered call hoping that the stock will be called away and thus achieving the target selling price. The “effective selling price” of a covered equals the strike price of the call plus the premium received. In the example above in which a 100-strike call is sold for 3.50 per share, the effective selling price is $103.50 (100.00 + 3.50) if the call is assigned. If the stock price rises above the strike price and the call is assigned, then the target selling price is achieved. If the stock price trades sideways or down, then the call expires and the call premium is kept as income. In this outcome, while the investor did not sell the stock as hoped, the investor benefitted from the call premium received.
- Some investors sell covered calls to get a limited amount of downside protection when they expect a stock to decline in price. A covered call provides only limited downside protection, because the stock price can decline much more than the call premium. Investors who sell calls for this reason must also watch out in case the bearish forecast is wrong. If the stock price rises, contrary to the forecast, then the covered call contains the obligation to sell the shares. If it is not the investor’s intent to sell the shares, and if the price rises, then the call must be repurchased in the marketplace so that the obligation to sell the shares is closed.
Impact of stock price change
The value of a short call position changes opposite to changes in underlying price. Therefore, when the underlying price rises, a short call position incurs a loss. Also, call prices generally do not change dollar-for-dollar with changes in the price of the underlying stock. Rather, calls change in price based on their “delta.” The delta of a short at-the-money call is typically about -50%, so a $1 stock price decline causes an at-the-money short call to make about 50 cents per share. Similarly, a $1 stock price rise causes an at-the-money short call to lose about 50 cents per share. In-the-money short calls tend to have deltas between -50% and -100%. Out-of-the-money short calls tend to have deltas between zero and -50%.
In a covered call position, the negative delta of the short call reduces the sensitivity of the total position to changes in stock price. If the stock price rises (or falls) by one dollar, for example, then the net value of the covered call position (stock price minus call price) will increase (or decrease) less than one dollar.
Impact of change in volatility
Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. As a result, short call positions benefit from decreasing volatility and are hurt by rising volatility. Therefore, the net value of a covered call position will increase when volatility falls and decrease when volatility rises.
Impact of time
The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion. Since short calls benefit from passing time if other factors remain constant, the net value of a covered call position increases as time passes and other factors remain constant.
Risk of early assignment
Stock options in the United States can be exercised on any business day, and the holder of a short stock option position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.
Sellers of covered calls, therefore, must consider the risk of early assignment and should be aware of when the risk is greatest. Early assignment of stock options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned.
Potential position created at expiration
If a call is assigned, then stock is sold at the strike price of the call. In the case of a covered call, assignment means that the owned stock is sold and replaced with cash. Calls are automatically exercised at expiration if they are one cent ($0.01) in the money. Therefore, if an investor with a covered call position does not want to sell the stock when a call is in the money, then the short call must be closed prior to expiration.
The “covered call” strategy is known by different names which have slightly different meanings. The name “buy-write” implies that stock is purchased and calls are sold at the same time. The name “over write” implies that stock was purchased previously and that calls are being sold against an existing stock position. The name “covered call” simply describes a short call position against which stock is owned and does not imply anything about the timing of the stock purchase relative to the sale of the call.