What is a Covered Call? Options Trading Strategy & How to Profit


What is a covered call?

A call option is a contract that gives buyers the right to buy a set amount of shares of an underlying stock at an agreed-upon price (aka: strike price) any time on or before a set expiration date. When you sell a call option for stock you already own, the transaction is considered a covered call, because you have a certain amount of protection (or, are covered) since you will not have to buy the stock at a future potentially unfavorable market condition to fulfill the call option.

Key Takeaways

  • Learn how to make money from covered calls
  • Calculate profits and break even points
  • Strategize for bull and bear markets
  • Learn how to buy and sell covered call options

Table of Contents:

  1. What is a covered call?
  2. How to make money from covered calls
  3. Calculating maximum profits and break evens
  4. Covered call strategy 101: when to use covered call
  5. Covered call strategy 101: when to avoid covered calls
  6. How Public can help you invest smarter
  7. Frequently asked questions

How to make money from covered calls

There is profit potential from both sides of covered calls. If you’re a call writer (aka: if you’re selling a covered call), the buyer pays you an “option premium,” or a cash fee for the stock option—whether or not they ever exercise the option to buy at the strike price. Therefore, by selling a covered call you can earn income from the long stock position. If the price of the stock stays below the strike price, the seller will make money because the buyer will either not exercise their call option or will buy at more than the stock is currently worth.

However, if the open market stock price rises above the strike price before the expiration date, the option holder may choose to exercise their option to buy the underlying stock for a purchase price less than it is currently worth, in which case the call holder profits.

  • Simple covered call example:

In 2020, stock EXMPLE is valued at $10 per share on the open market. Say a call writer sells a call option for a $200 option premium, agreeing to sell the call holder 100 shares of EXMPLE for the strike price of $15 per share any time before the expiration date 2030. Over the course of the next 10 years, EXMPLE is never valued over $13 so the option contract holder does not exercise their right to buy the stock at $15 per share. The call writer keeps the option premium and has profited by $200.

Covered Call example

Calculating maximum profits and break evens

There are simple formulas for calculating your potential profits from covered call writing or when you will break even. One thing to remember when looking at potential profit from call writing is that you must factor in money collected from premiums. Another is that any profit from buying or selling covered call options will be liable for capital gains taxes.

Maximum Profit

(Stock Purchase Price – Short Call) + Premium Received

Break Even Point

Stock Purchase Price – Credit Received

Covered call strategy 101: when to use covered calls

Understanding the temperature of the stock market to estimate your underlying stock’s target price is key to a covered call investment strategy. For an easy way to remember the difference between bear vs. bull markets, remember this: in a bull market, stock values are generally rising and investors feel opportunistic; in a bear market, stock values are generally dropping and investors may act impulsively out of fear.

In times when the market is staying sideways or turning downward (aka bear markets), covered call writing tends to generate significant income from call premiums, in addition to dividend profits from the underlying stocks.

Covered calls offer downside protection in a downmarket, because you can continue to generate income from premiums collected through call writing even as stock prices tank. Wondering whether a stock is sinking because of market volatility or for other reasons? Public’s “Why It’s Moving” feature explains why a stock or ETF is making big moves in the market, so you can decide whether it’s right for your strategy.

Your strategy will be based more on implied volatility than historical volatility of the market. Implied volatility is a dynamic measurement that approximates future value of a stock option, and the option’s current market price is also taken into consideration. Options with high implied volatility have higher premiums and vice versa. In low priced stocks with high volatility, some call writers or brokerages may employ a bullish strategy, buying and selling quickly based on the market movement.

Covered call strategy 101: when to avoid covered calls

In a strong upward market (aka bull market), it may not be the best time for call option writing. If the underlying stock price rises significantly above the strike price, it would have been a better choice to hold the stock instead of selling the call. However, the premium income still helps offset loss. Ultimately, a covered call is often considered a low-risk options strategy that minimizes downside risk in most markets.

Covered call strategy 201

Now that you understand the basics of how to use covered calls, we’ll go into further detail about strategies investors employ, including helpful new vocabulary to know.

Buy / Write

The ”Buy / Write” strategy describes a covered call strategy where you buy the underlying stock and sell the call on that stock at the same time, when equity is already moving in your favor. An investor may use a Buy / Write to lower the cost basis of a stock they’ve just purchased. To use this strategy, you may want to make use of the Public’s stock rating and price target data for every stock. See whether analysts recommend buying or selling a specific stock, plus their estimations for future pricing.

Public Stock Rating & Price Target

Sell off stock & make extra money

If you have stock you want to sell anyway, you can make additional income by selling calls on that stock. In this case, you want the stock to rise above the strike price and stay there until the expiration date, so that the call is assigned. If you’re using this strategy, for your own piece of mind don’t keep getting quotes on the stock. In case it rises very high above the strike price, just remember, you were going to sell anyway, and this way you made the premium. When deciding whether to trim a stock from your portfolio, use insights from Public’s premium feature to keep tabs on unique performance indicators, unlock Unlock analyst sentiment, check Morningstar’s fair-value estimate and more.

Public Premium Insights

OTM and ATM

A call is considered “Out-of-the-money” or OTM when the strike price is above the stock’s current market price and “at-the-money” or ATM when the strike price is at the stock’s current market price. When you write OTM or ATM calls, you’re hoping the option will expire worthless, and you get to keep the premium you received as well as the stock.

If the option is exercised for OTM and ATM calls, you will get money from the sale of the stock as well as the premium. In many cases, this means you will still profit, even though the stock’s price has risen.

Roll a call

To “roll” a call is to buy back your call and sell another on the same underlying stock with a later expiration date, meanwhile leaving your stock position alone. This could be a good choice if the underlying stock’s price is rising, but you think that rise is temporary.

How Public can help you invest smarter

As we mentioned before, understanding the market’s movement is crucial to successfully adding covered calls into your investment strategy. That’s why Public has a wide array of investing tools, with experts to help you understand why a stock, crypto, or asset is going up or down in real time.

Plus, you’ll get an insider’s look at what’s moving stock with our Town Hall feature that lets you ask questions directly to the company’s leaders.

Or, listen to Public Live, where experts update you every morning about what you need to know about the day’s market movements and explain the ins and outs of the crypto space.

Because we believe in putting financial power in everyone’s hands, signing up is free. After you’ve been investing for a while, you may want to level-up your portfolio with Public Premium, which lets you unlock exclusive research reports, analyst sentiments, detailed breakdowns of ETF holdings and more.

Frequently asked questions

Can you lose money on covered calls?

Yes, you can absolutely lose money selling covered calls, as with any trading strategy. Specifically, you may lose money if the underlying stock price rises significantly above the strike price set in the call option. However, you minimize risk since you are selling options for shares of stock you already own.

Do you need to exercise all covered calls?

No, you do not have to exercise all covered calls! They’re referred to as call options because they’re just that, the legal option, not obligation, to buy a share of stock at a preset price.

What is the difference between a covered and naked call?

A naked call is a trading option when the call writer does not already own the underlying stock, putting them at additional risk. A naked call has limited upside profit potential theoretically unlimited potential to lose money.

What is the maximum loss on a covered call?

The maximum loss on a covered call is calculated by starting with the initial investment in the stock and subtracting the option premium. The most you can lose on a covered call is the stock you already own, but you will always gain the premium in the process.

What is a Covered Put?

Writing a covered call sells someone else the right/option to buy a stock you own, but selling a covered put creates an obligation for you to buy the stock back at the strike price of the put option.This strategy is best used when you have a neutral to bearish sentiment.

The above content provided and paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.

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