Covered Call Strategy in Options Trading
Options trading offers various strategies for investors that can help manage risk and potentially generate returns. One such strategy is the covered call, which involves selling call options while simultaneously holding an equivalent position in the underlying asset. This guide explores the covered call strategy in detail, including its mechanics, advantages, risks, and when to use or avoid it.
What is a covered call?
A covered call is an options trading strategy that involves two main components: owning the underlying asset and selling call options against it. This strategy provides investors with an opportunity to generate income through the premiums received from selling the call options. By holding the underlying asset, investors have coverage in case the option is assigned.
Why consider a covered call strategy?
The covered call strategy can potentially provide benefits for investors. Investors can generate additional income through the premiums received from selling call options. This also offers a way to potentially profit from a neutral or slightly bullish market.
Theoretical maximum profit and maximum loss
Maximum profit
Maximum profit is achieved when the stock price remains below the call option's strike price at expiration. It is calculated as the difference between the strike price and the stock purchase price plus the premium received from selling the call option.
The maximum profit of a covered call is limited to the sum of the premium received from the sold call option and the gain from the stock's price rise up to the strike price of the call option.
For example
If an investor sells one call option with a strike price of $55 for a premium of $2 per share on 100 shares of a stock initially purchased at $50 per share. If the underlying stock rises to $55 at expiration, the maximum profit would be:
Maximum Profit = (Strike Price - Current Stock Price) + Premium Received x 100 shares
Maximum Profit = ($55 - $50) + ($2 x 100)
Maximum Profit = $500 ($5 X100 shares owned) + $200
Maximum Profit = $700
Maximum loss
Maximum loss can be significant and occur if the stock price drops to zero. However, since the investor already owns the underlying shares, their loss is somewhat cushioned by the premium received from selling the call option. The maximum loss is slightly reduced by the amount of premium received.
For example, if the stock price decreases to zero, the maximum loss would be limited to the purchase price of the stock minus the premium received from selling the call option.
Example of covered calls
Suppose an investor owns 200 shares of a company trading at $45 per share. They decide to sell one call option with a strike price of $50 for a premium of $3 per share. Here's a few scenarios.
If the price of XYZ drops below the initial $45 cost basis, the call options expires worthless; however, the investor's $3 premium from selling the call ($300 for one option contract) offsets some of the stock's decrease in the stock's market value.
If the price of XYZ remains below $50 at expiration, the investor keeps the premium as a profit.
If the price rises above $50, the investor may have to sell their shares at $50 but still keep the premium. However, as an option writer, they cannot participate in any price growth above the strike price, so their upside is capped by the option.
When to consider using covered calls?
Covered calls can be appropriate when investors aim to generate extra income from their stocks while managing some downside risk. This strategy tends to do well in stable or slightly bullish markets with low volatility, near resistance levels, or when seeking additional portfolio income and diversification. By understanding these opportune moments, investors may be able to effectively implement covered call strategies to potentially enhance their investment returns.
Strike price selection
When utilizing covered calls, consider the following for strike price selection:
Conservative Approach: Opt for out-of-the-money strike prices to help minimize assignment risk and maintain stock ownership.
Balanced Strategy: Choose close to at-the-money strike prices to align with an investor's market outlook while increasing the likelihood of the option being assigned. However, selecting an out-of-the-money strike price (a drawback is lower premiums) will help lower the chance of assignment, which can allow the investor to keep the premium as income.
Aggressive Strategy: Explore in-the-money options for higher premiums and limited downside protection, but be prepared for potential stock assignment.
Risk-Reward Assessment: Evaluate market conditions, volatility, and investment goals to optimize strike price selection in an attempt to maximize risk-adjusted returns.
How to Use Covered Calls using Moomoo
For a step-by-step guide to trading option on Moomoo, see here:
Step 1: Navigate to your Watchlist, then select a stock's "Detailed Quotes" page.
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 2: Navigate to Options> Chain located at the top of the page.
Step 3: By default, all options with a specific expiration date are shown. For selective viewing of calls or puts, simply tap "Call/Put."
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 4: Adjust the expiration date by choosing your preferred date from the menu.
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 5: Easily distinguish between options: white denotes out-of-the-money, and blue indicates in-the-money. Swipe horizontally to access additional option details.
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 6: Explore various trading strategies at the screen's bottom, offering flexibility for your investment approach.
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
When to avoid covered calls
Consider avoiding covered calls in high volatility, strongly bullish markets, ahead of earnings seasons, with high growth stocks, or when prioritizing portfolio protection. These situations may lead to increased risk of assignment, missed potential gains, and limited downside protection. Instead, consider alternative strategies aligned with investment objectives and risk tolerance.
Pros and cons of covered calls
Pros
1. Income generation: Covered calls allow investors to potentially generate additional income from their existing stock holdings by selling call options. This income received from the premiums can supplement any dividends and help enhance portfolio returns.
2. Limited downside protection: By selling call options against their stock holdings, investors receive premiums that provide some cushion against potential losses if the stock price falls. This limited downside protection helps mitigate risks associated with stock ownership.
3. Profit potential in neutral markets: Covered calls can profit from neutral or slightly bullish market movements. Even if the stock price remains relatively unchanged, investors can still earn income from the premiums received.
Cons
1. Limited upside potential: If the stock price rises above the strike price of the call option, the investor may miss out on additional gains, as the stock may be called away.
2. Potential risk of assignment: There is a risk of assignment if the stock price rises above the strike price of the call option before expiration. In such cases, the investor may be required to sell their shares at the predetermined strike price, potentially missing out on further upside potential.
3. Opportunity Cost: By selling call options against their stock holdings, investors may limit their ability to participate fully in any significant upward movements in the stock price. This opportunity cost could result in missed investment opportunities.
4. Market Volatility: Increased market volatility can affect options premiums, impacting the effectiveness of covered calls. Higher volatility may lead to higher premiums, but it also implies greater uncertainty and potential risks for investors.
FAQs about covered calls
Is a covered call bullish or bearish?
A covered call strategy is generally considered neutral to slightly bullish. It allows investors to generate income from receiving an options preimum from writing the call option. However, if the stock price rises above the strike price of the option, investors can forfeit potential stock gains.
Is there risk involved with covered calls?
Yes, there are risks involved with covered calls. While this strategy provides limited downside protection through the premium received, there is still the risk of potential losses if the stock price declines significantly or if the stock is called away at a price below its current market value.
Can you undergo losses on a covered call strategy?
Yes, it's possible to incur losses on a covered call. While the premium received provides some cushion against losses, if the stock price drops below the breakeven point (purchase price minus premium received), the investor may experience a loss. Additionally, if the stock price rises above the strike price of the call option, the investor may miss out on potential gains beyond that point.
What is a poor man's covered call?
A poor man's covered call is an alernative to the traditional covered call strategy. Instead of owning the underlying stock, the investor buys a longer-term in-the-money call option and sells near-term out-of-the-money call options against it. This strategy requires less capital but also offers higher potential returns compared to a traditional covered call.
Some drawbacks of this vs. a traditional covered call are the lack of potential dividends and time constraints as long equity positions are not constrained by an expiration date.
Are covered calls good in a recession?
Covered calls can generally be appropriate in a recessionary environment, especially for investors looking to generate income from their existing stock holdings. However, it's essential to consider market conditions and potential risks carefully before implementing this strategy during a recession. Volatility may increase, affecting options premiums and potentially impacting the effectiveness of covered calls.