What Is a Covered Call?

A covered call refers to a financial transaction in which the investor selling call options owns an equivalent amount of the underlying security. To execute this an investor holding a long position in an asset then writes (sells) call options on that same asset to generate an income stream. The investor's long position in the asset is the "cover" because it means the seller can deliver the shares if the buyer of the call option chooses to exercise. If the investor simultaneously buys stock and writes call options against that stock position, it is known as a "buy-write" transaction.

Key Takeaways

  • A covered call is a popular options strategy used to generate income in the form of options premiums.
  • To execute a covered call, an investor holding a long position in an asset then writes (sells) call options on that same asset.
  • It is often employed by those who intends to hold the underlying stock for a long time but does not expect an appreciable price increase in the near term.
  • This strategy is ideal for an investor who believes the underlying price will not move much over the near-term.

Covered Call

Understanding Covered Calls

Covered calls are a neutral strategy, meaning the investor only expects a minor increase or decrease聽in the underlying stock price for the life of the written call option. This strategy is often employed when an investor has a short-term neutral view on the asset and for this reason holds the asset long and simultaneously has a short position via the option to generate income from the option premium.

Simply put, if an investor intends to hold the underlying stock for a long time but does not expect an appreciable price increase in the near term then they can generate income (premiums) for their account while they wait out the lull.

A covered call serves as a short-term聽hedge on a long stock position and allows investors to earn income via the premium received for writing the option. However, the investor forfeits stock gains if the price moves above the option's聽strike price. They are also聽obligated to provide 100 shares at the strike price (for each contract written) if the buyer chooses to exercise the option.

A covered call strategy is not useful for a very bullish nor a very bearish investor. If an investor is very bullish, they are typically better off not writing the option and just holding the stock. The option caps the profit on the stock, which could reduce the overall profit of the trade if the stock price spikes. Similarly, if an investor is very bearish, they may be better off simply selling the stock, since the premium received聽for writing a call option will do little to offset the loss on the stock if the stock plummets.

Covered Call
Image by Julie Bang 漏 Investopedia 2019

Maximum Profit and Loss

The maximum profit of a covered call is equivalent to the strike price of the short call option, less the purchase price of the underlying stock, plus the premium received.

The maximum loss is equivalent to the purchase price of the underlying stock less the premium received.

Covered Call Example

An investor owns shares of聽hypothetical company聽TSJ. They聽like its long-term prospects as well as its share price but feel in the shorter term the stock will likely trade relatively flat, perhaps within a couple dollars of its current price of聽$25.

If they sell a call option on TSJ with a strike price of $27, they earn the premium from the option sale but, for the duration of the option, cap their聽upside on the stock to $27. Assume the premium they receive for writing聽a three-month call option is $0.75 ($75 per contract or 100 shares).

One of two scenarios will play out:

  • TSJ shares trade below the $27聽strike price.聽The option will expire worthless and the investor will聽keep the premium from the option. In this case, by using the buy-write strategy they have successfully outperformed the stock. They still own the stock but have an extra $75 in their pocket, less fees.
  • TSJ shares rise above $27. The option is exercised, and the upside in the stock聽is capped at $27. If price goes above $27.75 (strike price plus premium), the investor would have been better off holding the stock. Although, if they planned to sell at $27 anyway, writing the call option gave them an extra $0.75 per share.