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Most seasoned investors employ specialised options trading strategies to minimise their risk and limit their losses. One such options strategy that veteran traders and investors use on a day-to-day basis is the covered call. If you’re wondering what this is, here’s everything you should know about the covered call option strategy.
Key Takeaways
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A covered call option strategy allows investors to earn additional returns on their stock holdings.
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It provides limited protection against downside, but it also caps potential upside returns. The method is most effective in a neutral or slightly bullish market environment.
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Selling call options results in a premium, which is like partial coverage against losses.
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Covered calls are popular among experienced investors seeking consistent returns.
What Is A Covered Call?
The covered call strategy essentially involves an investor selling a call option contract of the stock that they currently own. By selling a call option, the investor essentially locks in the price of the asset, thereby enabling him to enjoy a short-term profit. Apart from this, the investor also gets a slight protection from any future declines in stock prices.
Understanding Covered Calls
A covered call option strategy combines owning a stock with the sale of a call option of that same stock. This approach is commonly used by investors seeking income through option premiums.
In simple terms, when an investor sells a call option, they are selling the holder of the call the right (but not the obligation) to buy their stock at a predetermined price, known as the strike price, within a specified time frame.
A covered call option strategy is usually relevant in cases where the investor anticipates a small increase in the price of the given stock. It can add a regular source of income and offer partial downside protection via the premium received. However, it also limits the upside potential for the investor if the stock price surges substantially.
Advantages And Disadvantages Of Covered Calls
Although the covered call strategy offers several advantages, it also has some limitations that investors should be aware of before using it.
Advantages
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Stable Revenue from Premiums: Covered calls can generate additional income through option premiums, potentially enhancing returns in flat or mildly rising markets. They work best when the stock trades in a stable range, offering reliable gains with limited price risk.
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Low Negative Exposure: Covered calls offer a cushion against small losses by lowering the breakeven point. This risk-managed approach appeals to conservative and institutional investors seeking steady income with limited downside.
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Defined Risk Profile: Covered calls offer clear, defined risk and reward. Since the stock is owned, losses are limited to price declines minus the premium, giving investors predictable, controlled exposure. The overall position still faces substantial downside risk if the stock declines significantly.
Investors often use covered calls to boost returns on high-quality holdings or the best stocks for covered calls that have stable price patterns and solid fundamentals.
Disadvantages
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Capped Upside Potential: If the stock price rises above the strike, profits stop there and extra gains go to the buyer, limiting returns for bullish investors.
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Share Obligation: Each call contract represents shares. If exercised, the writer must deliver shares or buy them at market price. For those looking for the best covered calls approach, targeting low-volatility stocks can yield steady returns with manageable risk.
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Poor Fit for Volatile Markets: Large price swings can reduce effectiveness as big drops hurt more than the premium helps, and big rallies cap profits.
When Should You Use The Covered Call Option Strategy?
The covered call is ideal for neutral and moderately bullish situations, where the future upside potential of the stock that you own is limited. This strategy is ideal when the outlook for the stock that you own is not very bright, and when booking short-term profits would be a better idea than keeping holding the stock.
How Does The Covered Call Strategy Work?
For utilizing a covered call option strategy, you’re required to first own the stock of a company. So, let’s assume that you already hold the stock of a company, i.e., going long. Your view when you bought the stock was bullish, but as time passed, you’re now unsure of the future upside potential for the stock, and so you don’t expect the price to rise much.
Under such a situation, what do you do? You can book a short-term profit and protect yourself from minor downsides in the price of the stock by using the call option contract of the stock. And so, you sell a call option contract of the stock at a strike price that’s higher than the purchase price of the stock. The buyer of the call option would, in turn, give you a premium, which you’re obligated to keep whether the option is exercised or not.
Now, here’s where things get exciting. After you execute a covered call strategy, one of three scenarios is likely to happen. Let’s take a look at them one after the other.
Scenario 1: The Price of the Stock Rises
In such a situation, since you’ve effectively locked in the sale price of the stock by selling a call option, you get to enjoy a guaranteed short-term profit. In addition to this, you also get to pocket the premium that the buyer of the call option paid you. Therefore, it is a win-win situation.
Scenario 2: The Price of the Stock Falls
In this scenario, you get limited protection from the downside thanks to the premium that you were able to pocket by selling the call option. This premium amount that you received can be used to reduce the impact of the loss that you had to suffer as a result of the fall in the stock price.
Scenario 3: The Price of the Stock Remains the Same
When the price of the stock remains neutral without any changes whatsoever, your profit would actually be the amount of premium that you were able to pocket by selling the call option contract of the stock. This is the case irrespective of whether the option is exercised by the buyer or not. Sometimes, the buyer might not want to exercise the option, in which case you get to enjoy the premium as well as hold onto you shares.
How to Use LEAPS in a Covered Call Write
A covered call strategy known as the “surrogate covered call write” offers the possibility to enhance overall performance by substituting long-term equity anticipation securities for stock as the underlying asset.
To illustrate this surrogate technique, consider a hypothetical covered call written on J.P. Morgan (JPM) stock. Assume that the JPMorgan Chase stock is trading at 35.72. If an investor is somewhat positive on JPM, they can use a classic covered call, which offers some minor upside potential.
If the investor wishes to hold a six-month covered call, he or she may sell the slightly out-of-the-money 37.50 call, which is currently trading at $1.60. If JPM closed at the strike price of the 37.50 call (the maximum profit point) at expiration, the profit would be $1.78 per share plus the entire $1.60 profit on the call option sold but which expired worthless. Thus, the maximum profit per share is $3.38. Additionally, there may be a minor gain from any dividends collected during this six-month period that is not included in this calculation.
Now, instead of purchasing JPM shares, the investor might acquire a deep-in-the-money LEAP call option with a strike price of 25 and a maturity date of twenty-four months, which is currently selling at $10.70 in our case. In other words, rather than owning J.P. Morgan stock, a two-year call option LEAP serves as a “surrogate” for actual ownership of the underlying.
In an ideal world, this technique would work in an established bull market, which is typically characterised by low implied volatility. We seek a low volatility environment because LEAPs have a high vega, or a higher price sensitivity to volatility swings. Otherwise, LEAPs follow the same basic pricing principles and parameters as standard stock options.
Due to the option’s deep in-the-money status, the LEAP premium represents solely intrinsic value (i.e., very little temporal value). Due to the short duration of this option, it will have a delta of 1.00. Thus, owning the LEAP functions as a proxy for owning the actual shares, but requires significantly less capital.
The owner of the LEAP can now sell the same JPM 37.5 call for $1.60 in exchange for this LEAP. If JPM closes at $37.5, the maximum profit is $3.38, the same as the prior example but with less upfront cash. As a result, the rate of return on capital employed is higher (ROCE).
Maximum Risk Mitigation
Assume that JPM closes at 30 instead of the maximum profit point anticipated above at the expiration of the options. As you can see, the standard covered call writing strategy results in a loss of $572 on the stock position ([$35.72 – $30] x 100 shares = $572). This loss is somewhat offset by the profit on the worthless July call, resulting in a net loss of $412 ($572 – $160 = $412).
The position would reflect the same loss amount for the LEAP-covered write. This assumes the LEAP maintains a delta score of 1.00, emulating the long stock position precisely. With a strike price of 25, the LEAP call is still firmly in the money at 30. As a result, it would have lost $412 ($572 – $160 = $412). However, if the stock price falls, the LEAP approach gains an edge.
For instance, if JPM closes at 25 at expiration, the loss on the standard write would be $500 greater at $912, whereas the LEAP-covered write can lose no more than $10.70 minus $160, or $910. Notably, the LEAP method might potentially result in a reduced loss at 25 if this scenario did not occur at the LEAP’s expiration. That would imply that there was still some time value remaining. If the LEAP retained its $1.50 time value, the $150.00 remaining premium would mitigate the projected loss.
Advantage of Volatility
When volatility is considered, the LEAP method becomes even more appealing. Due to the high vega of LEAPs, an increase in volatility would result in an increase in extrinsic (i.e. time value) value on a long LEAP position.
Additional Considerations
If interest rates rise, the position’s maximum loss would be further reduced, as call LEAPs appreciate in value as rates climb. However, dividends would have to be incorporated into the typical covered write, lowering the maximum loss.
Conclusion
One of the advantages of the covered call is the fact that you don’t have to time the purchase of your stock and the sale of the call option contract. You can sell the call option anytime after you’ve purchased the stock. That said, it is a good idea to always exercise a bit of caution when dealing with options and options strategies due to the amount of risk involved.
Example of a Covered Call
Let us consider a covered call example of an investor holding 100 shares of XYZ Ltd, a stock currently priced at ₹500 per share. They choose to sell one contract of a call option with the strike price of ₹520, which will expire one month later, and get paid a premium of ₹10 per share.
If the stock is below ₹520 at expiry, then the option will expire worthless. The investor receives the shares and also the ₹10 premium, thus earning additional income.
However, if the price of the stock exceeds ₹520, the buyer will exercise the option, and the investor must sell the shares at ₹520. In this case, the investor still makes a profit, but only up to the strike price plus the premium earned.