Table of Contents
- What Is a Covered Call?
- Why Use This Strategy?
- Understanding Covered Calls
- Maximum Profit and Maximum Loss
- Advantages and Disadvantages of Covered Calls
- When to Use and When to Avoid Covered Calls
- Alternatives to Covered Calls
- Rolling Covered Calls
- Example of a Covered Call
- Are Covered Calls Profitable?
- Are Covered Calls Risky?
- Can I Use Covered Calls in My IRA?
- Is There Such a Thing As a Covered Put?
- The Bottom Line
What Is a Covered Call?
Let me explain what a covered call is: it's when you, as a seller who owns shares in the underlying stock or asset, sell call options on those shares. By doing this, you're creating an extra income stream through the premiums you collect from the options, all while keeping your stock holdings. In the worst case, if the buyer exercises the option, you'll have to deliver the shares, but since you own them, it's covered.
Why Use This Strategy?
You'd typically use a covered call when you plan to hold the shares long-term but don't anticipate a big price jump before the option expires. It's a way to make money from the premium without expecting sharp increases in the stock value.
Key Takeaways
- As the seller, you expect only minor ups or downs in the stock price during the option's life.
- You want to keep the stock but see no major near-term price rise.
- The goal is to pocket the options premium as ongoing revenue from your stock position.
Understanding Covered Calls
Covered calls are a neutral strategy, meaning you only expect small changes in the stock price while the call option is active. If you have a short-term neutral view on the asset, you hold it long and take a short position through the option to earn that premium income. Simply put, if you're in it for the long haul but think the stock will stay flat soon, you can generate premiums to tide you over. This acts as a short-term hedge on your long stock position, letting you earn from the premium, but remember, if the stock surges above the strike price, you forfeit those extra gains, and you're on the hook to deliver 100 shares per contract if exercised.
Maximum Profit and Maximum Loss
The max profit from a covered call equals the premium you receive plus any stock upside from current price to the strike. For example, if the stock is at $90, you sell a $100 strike call for $1 premium, your max per share is $11 ($10 gain plus $1 premium). On the flip side, max loss is the stock's purchase price minus the premium, since the stock could theoretically drop to zero, leaving you with just the premium. If you buy the stock and write the calls at the same time, that's a buy-write transaction.
Advantages and Disadvantages of Covered Calls
One advantage is reliable premiums: you earn from selling the call, but if it goes in the money, you might lose potential profits and have to deliver shares—or buy more if short, which adds losses. Losses are limited, making this quantifiable for funds and traders, but it caps profits too. It's not great for very bullish or bearish views; if you're super bullish, just hold the stock without writing the option to avoid capping gains.
Pros and Cons
- Pros: Limits risks in options contracts and earns premium from small price increases.
- Cons: Must deliver 100 shares per in-the-money call, and very bullish investors might profit more from uncovered calls or just buying the stock.
When to Use and When to Avoid Covered Calls
Sell covered calls when the stock has neutral to positive long-term outlook with low chance of big swings—this lets you reliably profit from premiums. Avoid them if the stock might swing wildly; a big rise means missing gains above the strike, and a big drop could wipe out the stock value minus premium.
Alternatives to Covered Calls
A close alternative is the cash-secured put, where you sell a put and set aside cash to buy the stock if assigned—it's like a mirror of covered calls for neutral to slightly bullish views, generating upfront premiums when you're open to buying lower. Another is the collar: hold stock, sell a call, buy a put for downside protection, though it cuts income compared to plain covered calls. For more complexity, try diagonal spreads: buy a long-term call and sell a short-term one at different strikes to play time decay and volatility.
Rolling Covered Calls
Rolling a covered call means closing your current call and opening a new one with different terms. Roll up by moving to a higher strike when the stock rises, recapturing upside while collecting new premium. Roll down defensively if the stock falls, selling at a lower strike for higher relative premium but less upside. Roll out to extend expiration, keeping the position for more income, and you can combine these adjustments.
Example of a Covered Call
Suppose you own shares of TSJ at $25, liking its long-term but expecting it flat short-term. Sell a $27 strike call for $0.75 premium. If TSJ stays below $27, the option expires worthless, you keep the $75 per contract and the stock. If it rises above $27, it's exercised, capping your gain at $27 plus premium; above $27.75, you'd have been better just holding, but if you planned to sell at $27 anyway, the premium is extra.
Are Covered Calls Profitable?
Covered calls can be profitable or not, like any strategy. Peak payoff is if the stock hits the strike exactly, giving you the full premium plus modest rise. Used right, they reduce costs or generate income, but weigh the pros and cons.
Are Covered Calls Risky?
They're relatively low risk, limiting upside if the stock keeps rising and offering little protection on drops. Unlike naked calls with unlimited loss, covered ones are safer since you own the shares.
Can I Use Covered Calls in My IRA?
Yes, if your IRA custodian allows options trading. It's advantageous in IRAs to avoid capital gains taxes, letting you buy back or generate income for distributions or reinvestment without tax worries.
Is There Such a Thing As a Covered Put?
Puts let you sell the underlying at a set price. A covered put might involve shorting shares and selling a put, but it's uncommon. Instead, consider a married put: hold stock long and buy a put for downside protection.
The Bottom Line
A covered call lets you profit from expected price rises by offering to sell your securities at a set future price. It has lower upside than some strategies but also lower risk—use it wisely for neutral positions.
Other articles for you
Decoupling in finance refers to the divergence in expected correlations between asset classes, markets, or economies.
Workers' compensation coverage A is an insurance policy that provides benefits to employees injured or killed on the job, fulfilling state requirements without regard to liability.
A direct participation program (DPP) is a pooled investment vehicle that provides investors with access to cash flows and tax advantages from ventures like real estate or energy, typically structured as limited partnerships or REITs.
The Natural Gas Storage Indicator is the EIA's weekly report on working natural gas volumes in underground storage, influencing market prices through inventory changes.
A merger combines two companies into one new entity to enhance market share, reduce costs, or expand operations.
An onerous contract is one where fulfillment costs exceed expected benefits, requiring recognition as a liability under IFRS but not under U.S
Bootstrapping is a self-funding method for starting and growing a business using personal resources and revenues instead of external investments, offering control but with financial risks.
A liquidity adjustment facility is a monetary policy tool used by the Reserve Bank of India to help banks manage short-term liquidity through repos and reverse repos.
Behavioral economics examines how psychological factors lead people to make irrational economic decisions that deviate from traditional economic models.
Holding costs refer to the expenses incurred from storing unsold inventory, and minimizing them is key to effective supply chain management.