What Is a Covered Call?
A covered call is a risk management technique and an options strategy that entails retaining a long position in the stock while selling a call option on the underlying asset. Typically, investors who believe the underlying asset will experience relatively minimal price changes may use this technique.
The primary benefit of the covered call strategy is that an investor obtains a guaranteed income from the sale of a call option as a premium. If the underlying asset’s price rises marginally, the premium will boost the total return on investment. Furthermore, if the underlying asset’s price falls marginally, the premium will compensate for the loss.
The Benefits of Selling Covered Calls for Income
PFE, Pfizer, is currently trading at $42; a call option to buy PFE at $45 in one month is priced at $1. To start a covered call on PFE stock, an investor would buy 100 shares and sell a call option that obligates him to sell PFE at $45 in one month if the option buyer exercises it. We’ll ignore commissions for the sake of simplicity.
On the date of the transaction, the seller receives the premium from writing the covered call, which in this case is $100. The seller will keep the 100 shares of stock and the $100 he received for the option if the price remains below $45 at option expiration.
The call option will be exercised if the stock price is more than $45 at the time of expiration. The investor’s profit is equal to the $100 earned for selling the option plus the $300 in capital appreciation (100 shares * ($45 sell price – $42 purchase price) for a total profit of $400.
The premium received may be used to offset a drop in the stock price. If the stock were selling at $39 on expiration day and the investor elected to sell his shares, the total loss would be $200. The loss of $3 on the stock is compensated by the $1 in option premium received. The investor, on the other hand, does not need to sell the shares and can just wait for the call option to expire. The investor can sell another call option and receive the premium, lowering the cost basis of the stock purchase even further.
In our scenario, the investor bought PFE stock at $42 a share and sold a $45 covered call for $1 at the start of the first month. PFE was trading at $39 a month later, and the $45 call option had expired worthless. After that, the investor sold a monthly $40 call for $1.5. The stock’s cost basis at this time is $39.5, which is the purchase price of $42 less the $1 premium earned from the $45 call and the $1.5 premium received from the $40 call. When the covered call is assigned a month later, assuming PFE is trading at $41, the investor agrees to sell the stock at $40. The investor will make a profit of $0.5 a share, or $50 in total, on this purchase.
If the covered calls were not written on the stock, the investor would be $1 in the hole two months after the initial buy, which is the current price of $41 minus the purchase price of $42.
The Not-So-Great about Selling Covered Calls
The call seller does not get the entire benefit if the stock climbs significantly above the strike price. In our example, if PFE stock climbs to $60 in a month, the investor forfeits the extra $15 gain by selling the $45 call, which commits the investor to selling the shares at $45. The profit earned by the call seller is restricted to the premium received plus the difference between the stock’s purchase price and the strike price of the option.
The option seller must first purchase back the call option before selling the underlying shares. A large drop in the stock price that is higher than the premium will result in a loss on the transaction as a whole. Losses resulting from a drop in the underlying stock’s price are limited only by the premium received.
If the PFE stock declines to $37 a share in a month, the investor loses $5 on the stock; however, the loss can only be offset by the call option sold, in this case $1 at most, resulting in a total loss of $4 rather than $5 without the covered calls.
If the time to buy-back the call is only a few weeks away from expiration, the call may still be worth something. For example, two weeks before the expiration date, the investor needed to sell the holdings to cover some unexpected expenses. The $45 call had a $0.10 ask price. At the time of writing, the stock was trading at $37. The loss would be $4.1, calculated as the purchase price of PFE at $42 minus the current price of PFE at $37 minus the $1 premium on the $45 call, plus the 10 cents to buy it back. Even so, it’s a better result than a $5 loss when no covered calls were written.