Fundamentals
Covered Call
A covered call is when an investor sells a call (typically out-of-the-money), but owns the underlying equity. In exchange for giving someone else the right to buy the stock you own at a specific strike price within a set time frame, you receive a premium. It is a common strategy that investors use to earn additional income from their stock positions without typically taking on a large amount of risk.
- Outlook: Bullish or Neutral
- Use: Primarily used to generate income on your position by using your shares as collateral if you expect the stock price to remain relatively flat or increase only moderately
- Profit: You’ll profit if the stock price rises above your breakeven (equity cost basis + premium received)
- Loss: You’ll incur losses if the stock price falls below your breakeven (equity cost basis + premium received)
Additional uses
In addition to income generation, covered calls can serve several other purposes. They can hedge a position by using the premium collected from selling the call to offset either the price paid to purchase the asset or any potential losses. Covered calls can also be used to lower the net effective cost of your shares. Or, they can be used to close a position if you want to sell an asset assuming it rises to a specific price.
Risks
It’s important to balance the rewards of covered calls with the benefits. Covered calls don’t offer substantial protection if the price declines, beyond offsetting a portion of the losses with the option premium. By selling a covered call, you also give up potential profit if the stock price rises beyond the strike price. This is very important to remember as your position’s upside potential is capped with a covered call.
Basic example
Let’s say you own 100 shares of FlyFit, which you bought for $50 each. Believing that FlyFit’s price will remain relatively flat, you sell a call option with a $55 strike price that expires in a month. In return, you get a $3 premium.
- Strike price: $55Strike price represents the price you’d receive if your call were to be assigned
- Contract price: $3Per-share price of the option contract
- Total sale proceeds: $300Options have a contract multiplier, or the number of shares presented. Total sale proceeds is the contract premium x the contract multiplier, or $3 x 100 for this FlyFit option
- Collateral: 100 FlyFit sharesRequired shares in the event that your option is assigned and you must sell 1 contract x 100 shares
Since you are selling the call option, you will immediately generate $300 from the proceeds received when your order is executed, netting out any add’l fees charged by your Broker.
Maximum profit and loss
The P/L calculations take into consideration both the long stock position and the short call position.
- Max loss: $4,700The maximum loss of a covered call is the price you paid to purchase FlyFit minus the option premium received
- Breakeven: $48Price paid to purchase FlyFit - premium collected
- Max profit: $800The max profit is the difference between strike price minus the price paid to purchase FlyFit plus the premium collected
The max profit occurs if the stock price rises above the strike price, and your call is assigned.
Profit if...
FlyFit’s stock price is above your breakeven.
- Total profit: ($55 - $50 + $3) x 100 = $800Difference between strike price and the price paid to purchase FlyFit plus the premium collected x the number of shares represented (usually 100)
If FlyFit's stock price rises above the strike price of $55, then the buyer of your call option might exercise their right to buy your shares at $55. Since you originally paid $50 per share, you stand to make a $5 profit per share or $500 total. But remember, you still get to keep your $300 premium collected. Thus, your net profit is $800.
Loss if...
FlyFit’s stock price falls below your breakeven. That means you did not receive enough sale proceeds to offset the current decline in market price.
- Total loss: ($50 - $30) x 100 - $300 = $1,700Difference between the price you paid to purchase FlyFit and the current market price x the number of shares represented (usually 100), minus the option premium received
In the scenario above, you’d purchased 100 shares of FlyFit for $50 per share, or $5,000 total. FlyFit has declined to $30 per share. Your unrealized losses are $2,000. However, since you initially made a premium of $300 for selling the call option, your net loss is only $1,700 instead of $2,000.
Reminder: Income generation
Remember, covered calls are often used by investors who plan to hold the underlying equity for a long time but do not expect a substantial price increase during the duration of the call option.
In the example above, say you don’t expect FlyFit to rise to $55, but are relatively bullish on FlyFit in the long term and want to hold your FlyFit equity position. If at expiration, FlyFit stays below $55, the call option will expire worthless. This means that you’ve made the $300 option premium, capturing it as a realized gain, while still getting to keep your FlyFit shares.
In the example above, say you don’t expect FlyFit to rise to $55, but are relatively bullish on FlyFit in the long term and want to hold your FlyFit equity position. If at expiration, FlyFit stays below $55, the call option will expire worthless. This means that you’ve made the $300 option premium, capturing it as a realized gain, while still getting to keep your FlyFit shares.
Brokerage services for US-listed securities and options offered through Public Investing, member FINRA & SIPC. Supporting documentation upon request.
The examples used above are fictional, and do not constitute a recommendation or endorsement of any investment.
Options are not suitable for all investors and carry significant risk. Certain complex options strategies carry additional risk. There are additional costs associated with option strategies that call for multiple purchases and sales of options, such as spreads, straddles, among others, as compared with a single option trade.
Prior to buying or selling an option, investors must read the Characteristics and Risks of Standardized Options, also known as the options disclosure document (ODD).
Option strategies that call for multiple purchases and/or sales of options contracts, such as spreads, collars, and straddles, may incur significant transaction costs.
The examples used above are fictional, and do not constitute a recommendation or endorsement of any investment.
Options are not suitable for all investors and carry significant risk. Certain complex options strategies carry additional risk. There are additional costs associated with option strategies that call for multiple purchases and sales of options, such as spreads, straddles, among others, as compared with a single option trade.
Prior to buying or selling an option, investors must read the Characteristics and Risks of Standardized Options, also known as the options disclosure document (ODD).
Option strategies that call for multiple purchases and/or sales of options contracts, such as spreads, collars, and straddles, may incur significant transaction costs.
Options resource center
Options Foundations
Fundamentals
Chapter 9Long call
Chapter 10Long putChapter 11Protective put
Chapter 12Covered call
Chapter 13Cash-secured putMulti-leg Strategies