A covered call is a risk management and an options strategy that involves holding a long position in the underlying asset (e.g., stock) and selling (writing) a call option on the underlying asset. The strategy is usually employed by investors who believe that the underlying asset will experience only minor price fluctuations.
The main advantage of the covered call strategy is that an investor receives a guaranteed income as a premium from the sale of a call option. If the price of the underlying asset slightly increases, the premium will raise the total return on the investment. In addition, if the price of the underlying asset slightly declines, the premium will offset the loss portion.
It is not recommended to use a covered call strategy if you expect a substantial appreciation of the underlying asset because your profits are locked to the strike price of the call option. At the same time, if the price of the underlying asset significantly declines, the premium from the sale of the call will now cover only a small portion of the losses.
Example of a Covered Call
Here’s a simple example of a covered call strategy. You’ve decided to purchase 100 shares of ABC Corp. for $100 per share. You believe that the stock market will not experience significant volatility in the near future. You also predict that the share price of ABC Corp. will grow to $105 in the next six months.
In order to lock up your profits, you sell 1 call option contract with the strike price of $105 that will expire in six months (note that one call option contract consists of 100 shares). The premium on this call option is $3 per share in the contract.
Your future payoff depends on the price of the stock in six months. You face three scenarios:
Scenario 1: Stock price remains at $100 per share.
In such a scenario, the buyer will not exercise the call option because it is out-of-money (strike price exceeds the market price). Since the price will remain unchanged, you will not earn any return from the stock. However, you will earn $3 per share from the call premium.
Scenario 2: Stock price increases to $110.
If a stock price increases to $110 per share after six months, the buyer will exercise the call option. You will receive $105 per share (strike price of the option) and the $3 per share from the call premium. In this covered call scenario, you’ve sacrificed a small portion of potential profit in return for risk protection.
Scenario 3: Stock price decreases to $90.
In such a case, the call option will expire similarly to scenario 1. The stock will lose $10 per share in value, but the call premium of $3 per share will partially offset the loss. Thus, your final loss will be $7 per share.