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Cover Your Bets: How do Covered Calls Work

Updated: Dec 4, 2023

In today's dynamic financial landscape, mastering various investment strategies is crucial to achieving long-term success. One such powerful approach is options trading, which offers a plethora of opportunities for both risk management and income generation. In this comprehensive guide, we will focus on the covered call strategy, a popular and relatively conservative method for profiting from options trading.

Covered Calls

As you navigate through this tutorial on options trading, you will gain insights into crucial aspects such as the best stock-covered calls, how covered calls work, and when to employ this strategy for optimal results.


Let's dive into the fascinating world of options trading and discover how this powerful technique can enhance your portfolio's performance.

What is a Covered Call?

A covered call is a fundamental options trading strategy that involves selling or writing a call option for every lot of shares of the underlying stock that an investor owns. This relatively simple trading strategy generates income from a stock position while limiting potential losses through a hedged approach.


Covered call options come into play when the call option reaches its expiration date. At this point, one of two outcomes will occur -

  1. If the stock price closes above the call's strike price (the price at which the call goes in the money), the call buyer purchases the stock from the call seller at the strike price. The call seller retains the option premium.

  2. If the stock price closes below the call's strike price, the call seller keeps both the stock and the option premium. In this scenario, the call buyer's option expires worthless.

What’s the Difference Between a Normal Call Option and a Covered Call?


To understand how a covered call differs from a regular call strategy, it is important to compare the two different approaches.

Covered calls involve selling call options on a stock the investor already owns. This strategy allows investors to generate additional income from their holdings and limit potential losses, protecting against market volatility.


This approach is particularly appealing to those looking to enhance their income (think of covered calls as dividends) without taking on excessive risk.


On the other hand, naked calls (or selling regular call options) involve selling call options without owning the underlying stock, making it riskier.


The potential rewards are higher, as the seller profits from the call option's premium if the stock price remains below the strike price. However, it is generally reserved for experienced investors with margin accounts due to the substantial risks involved.

Covered Calls Example


Let’s look at a covered call example to understand how to profit from the strategy.

MSFT chart covered calls example

You believe that the stock market won’t experience a lot of fluctuation over the next three months and that Microsoft stock will increase by around $9/share.


Microsoft is currently trading at $288 per share, and a call option with a strike price of $297 expiring in three months costs $9. The contract costs a premium of $450, or $9 * 1 contract * 50 shares per contract.

To execute a covered call, you buy 50 shares of Microsoft for $14,400 and then sell one call to receive $450. Let’s consider three different examples to see how covered calls work to both maximize returns and minimize losses.

Scenario 1: Microsoft Stock Price Increases to $303/Share

In the first scenario, we will assume that Microsoft stock rises by 5% to $303 over the next three months due to an easing of financial conditions from a macroeconomic perspective, as well as an improvement in earnings, including revenues margins due to integration of AI features across the company’s product lines.

In this case, the option buyer will likely exercise the option, as the stock price is above the strike price. As a result, you, as the investor, will be obligated to sell your 50 shares at the agreed strike price of $295/share. As a result, your return will be:

  1. Profits From Selling the shares - Selling Price ($297) - Purchase Price ($288) * 50 Shares = $450

  2. Premium Received From the Call Options - $9 * 50 = $450

Thus the total returns in this scenario are the Total profit from the share sale ($450) + the total Premium received from the call option ($450). = $750.


Scenario 2: Microsoft Stock Price Stays Flat at $288/Share

In the second scenario, Microsoft stock remains relatively steady and doesn’t experience any fluctuations, trading at $288/share at the end of the three months. Since the buyer is out of the money (the stock price is below the strike price), they will not exercise the option


You will keep the premium and still own the 50 shares in this scenario. As a result, your return will be -

  1. Premium Received From the Call Options - $9 * 50 = $450.

The total return in this scenario will be the premium collected from writing the call option, which is = $450.

Scenario 3: Microsoft Stock Price Falls to $268/Share

Now let’s look at a third scenario, where Microsoft stock falls due to challenging market conditions and fears about a prolonged recession in the US due to heightened interest rates, which has led to a broader drawdown in equities. In this scenario, Microsoft stock goes down by around 7% or $20/share, making the new price $268/share.


In this case, the option buyer will not exercise the option, as the stock price is below the strike price. You will keep the premium and still own the 50 shares. As a result, your return in this scenario will be -

  1. Loss From Selling the shares - Selling Price ($268) - Purchase Price ($288) * 50 Shares = -$1000

  2. Premium Received From the Call Options - $9 * 50 = $450

Thus the total returns in this scenario are the Loss from the share sale (-$1000) + the total Premium received from the call option ($450). = $750.

Advantages and Drawbacks of Covered Calls


Advantages

One of the main appeals of covered calls is the ability to generate additional income from stock positions, even those that don't pay dividends. This can enhance a portfolio's overall profitability, especially those that focus on long-term fundamentals. As a relatively low-risk strategy, covered calls are well-suited for investors seeking a conservative approach to options trading.


Moreover, covered calls can serve as a risk management tool, as the income generated from selling the call options can offset potential losses in the underlying stock. This hedging aspect is particularly valuable in times of market uncertainty. Additionally, the recurring nature of the strategy allows investors to continue re-establishing covered calls, creating a steady income stream over time.


Drawbacks


Despite the benefits, covered calls also have their limitations. One of the most significant drawbacks is the trade-off between limited upside potential and bearing the downside risk of the stock. This can result in an imbalanced risk-return profile, especially if the stock experiences a significant price increase.

Furthermore, implementing a covered call strategy can restrict an investor's flexibility, as they may feel committed to holding the stock until the option expires. This can be particularly challenging in a rapidly changing market, where quick decisions are often required.

Best Situations to Use a Covered Call


When to Use a Covered Call

  1. Stable or Slowly Rising Stock Prices: If an investor anticipates that a stock price will remain relatively stable or experience only slow growth, a covered call can generate income while minimizing the risk of losing potential gains.

  2. Supplementing Dividend Income: Covered calls can be a suitable strategy for investors looking to supplement their dividend income, as the option premiums can effectively create an additional source of revenue from their stock holdings.

  3. Maximizing Tax Efficiency: Utilizing covered calls within a tax-advantaged account, such as an IRA, allows investors to defer or avoid taxes on the income generated from the options and the capital gains from having the stock called away.

When to Avoid a Covered Call

  1. Expecting Significant Stock Growth: If an investor anticipates substantial appreciation in a stock's value, they should avoid using a covered call. This strategy could limit their upside potential, as the stock could be called away at a lower strike price.

  2. High Downside Risk: When a stock has a considerable risk of experiencing a significant decline, a covered call may not be the ideal strategy. In such cases, investors should consider selling the stock or exploring other strategies to capitalize on the potential decline.


Bottom Line

The covered call strategy is a valuable addition to any investor's toolkit, offering opportunities to generate income, manage risk, and diversify investment approaches. By understanding the intricacies of covered calls and recognizing the most suitable market conditions for their application, you can make the most of this relatively conservative options trading strategy. It's essential to continuously monitor market trends, reevaluate your portfolio, and adapt your strategies as needed to ensure your investments remain aligned with your financial goals.


Frequently Asked Questions


Q: What are leaps-covered calls, and how do they differ from regular-covered calls?

A: LEAPS (Long-term Equity AnticiPation Securities) covered calls that involve selling call options with expiration dates further into the future, typically more than a year. While regular covered calls focus on generating income in the short term, leaps-covered calls aim to collect higher premiums and provide a longer time frame for potential stock appreciation.


Q: What are the best stocks for covered calls?

A: The best stock for covered calls are typically those written on stable or slowly rising stocks, which can generate consistent income while minimizing the risk of the stock being called away at an unfavorable price.


Q: How can I practice options trading, like covered calls, before investing real money?

A: Simulated options trading platforms offer a risk-free environment for you to practice various strategies, including covered calls, without using real money. These platforms typically provide virtual cash to invest, allowing you to gain experience and confidence in your trading skills before investing your capital.

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