Covered calls defined
A covered call is a two-part strategy in which stock is purchased or owned and calls are sold on a share-for-share basis.
The term “buy write” describes the action of buying stock and selling calls at the same time. The term “overwrite” describes the action of selling calls against stock that was purchased previously.
An example of a buy write is when an investor buys 500 shares of stock and simultaneously sells 5 call options.
An example of an “overwrite” is when an investor has owned 500 shares for some time and now decides to sell 5 calls against those shares.
Whether the shares are purchased before the calls are sold or purchased at the same time, the resulting position is described as a “covered call position.”
Potential benefits of a covered call
Covered calls offer investors three potential benefits.
- The premium received from selling a covered call can be kept as income.
Many investors use covered calls for this reason and have a program of selling covered calls on a regular basis – sometimes monthly, sometimes quarterly – with the goal of adding several percentage points of cash income to their annual returns.
- Selling covered calls can help investors target a selling price for the stock that is above the current price.
For example, a stock is purchased for $39.30 per share and a 40 Call is sold for 0.90 per share. If this covered call is assigned, which means that the stock must be sold, then a total of $40.90 is received, not including commissions. Even if the stock price only rises to $40.50, assignment means that a total of $40.90 is received. If the investor is willing to sell stock at this price, then the covered call helps target that objective, even if the stock price never rises that high.
- Another reason some investors sell covered calls is to get a limited amount of downside protection.
In the example above, the premium received of $0.90 per share reduces the break-even point of owning this stock and, therefore, reduces risk. Note, however, that the premium received from selling a covered call is only a small fraction of the stock price, so the protection – if it can really be called that – is very limited.
Risks of a covered call
There are two risks to the covered call strategy.
- The real risk of losing money if the stock price declines below the breakeven point.
The breakeven point is the purchase price of the stock minus the option premium received. As with any strategy that involves stock ownership, there is substantial risk. Although stock prices can only fall to zero, this is still 100% of the amount invested, so it is important that covered call investors be suited to assume stock market risk.
- The opportunity risk of not participating in a large stock price rise.
As long as the covered call is open, the covered call writer is obligated to sell the stock at the strike price. Although the premium provides some profit potential above the strike price, that profit potential is limited. Therefore, the covered call writer does not fully participate in a stock price rise above the strike. In the event of a substantial stock price rise, covered call writers often feel that they “missed a great opportunity.”
Covered call writing is suitable for neutral-to-bullish market conditions. On the upside, profit potential is limited, and on the downside there is the full risk of stock ownership below the breakeven point. Therefore, investors who use covered calls should answer the following three questions positively.
Are you willing to own the stock if the price declines?
- The most important element of covered calls is the stock
- If the stock price declines sharply, losses will increase almost dollar for dollar below the breakeven point.
- It is therefore important to focus on “good quality” stocks that you are willing to own through the inevitable ups and downs of the market.
Are you willing to sell the stock if the price rises?
- Since covered calls involve the obligation to sell stock at the strike price of the call, you must think about that obligation.
- If you have a stock that you have owned for years and expect to own for years more, you really have to think hard about whether or not you want to sell covered calls on that stock.
- Also, if you have a sizable unrealized profit in that stock, then selling it could trigger a substantial tax liability. On such a stock, it might be best to not sell covered calls.
- Generally, covered calls are best when the investor is not emotionally tied to the underlying stock. It is generally easier to make rational decisions about selling a newly acquired stock than about a long-term holding.
Are you satisfied with the static and if-called rates of return?
- At-the-money calls tend to offer higher static returns and lower if-called returns.
- Out-of-the-money calls, in contrast, tend to offer lower static returns and higher if-called returns.
- Which is right for you? There is no absolute “right” answer to this question. It is a subjective decision that each investor must make individually.
A covered call, which is also known as a “buy write,” is a two-part strategy in which stock is purchased and calls are sold on a share-for-share basis.
Covered calls offer investors three potential benefits, income in neutral to bullish markets, a selling price above the current stock price in rising markets, and a small amount of downside protection.
Investors should also be (1) willing to own the underlying stock, (2) willing to sell the stock at the effective price, and (3) be satisfied with the estimated static and if-called returns. Losses occur in covered calls if the stock price declines below the breakeven point. There is also an opportunity risk if the stock price rises above the effective selling price of the covered call.
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