What is a covered call?
A covered call is when you sell someone else the right to purchase a stock that you already own (hence “covered”), at a specified price (strike price), by a certain date (expiration date). When it’s structured properly, both time and price can work in your favor.
Covered calls are one of the most common and popular option strategies and can be a great way to generate income in a flat or mildly uptrending market. They also offer limited risk protection—confined by the amount of premium received—that can sometimes be enough to offset modest price swings in the underlying equity.
If you own stock that has declined sharply in price since the purchase date, covered calls are probably not the best choice for trying to recover some of your losses. It’s also important to note that a covered call writer (seller) relinquishes any profitability above the strike price.
When do you use a covered call?
Investors typically write covered calls when they have a neutral to slightly bullish sentiment. In many cases, the best time to sell covered calls is either at the time a long equity position is established (buy/write), or once the equity position has already begun to move in your favor.
When establishing a covered call position, most investors sell options with a strike price that is at-the-money (ATM) or slightly out-of-the-money (OTM). If you select OTM covered calls and the stock remains flat or declines in value, the options should eventually expire worthless, and you’ll get to keep the premium you received when they were sold without further obligation. If you select ATM covered calls and the stock declines in value, they too should expire worthless and the outcome is essentially the same.
If the stock appreciates in value above the strike price, you’ll probably have your stock called away (assigned) at the strike price, either prior to or at expiration. This may be a good thing. If you sold ATM or OTM calls, the trade will generally be profitable. Unless your options are deep in-the-money (ITM), that profit will usually exceed the one you would have earned if you had bought the stock outright and sold it at the appreciated price. It is also the maximum profit that can be earned on a covered call trade.
A covered call example
Here’s a hypothetical example of a covered call trade. Let’s assume you:
- Buy 1,000 shares of XYZ stock @ 72
- Sell 10 XYZ Apr 75 calls @ 2
Because you bring in two points for the covered call, it provides two points of immediate downside protection. In other words, you will not have a loss unless the stock drops below $70.
NYC Journals 