Home: What is a covered call?
Covered call writing is typically the first strategy new option traders attempt. It is also popular with experienced traders who want to earn extra income from stocks they already own. It is commonly regarded as one of the option strategies with the least amount of risk.
In simple terms, a covered call is a contract to sell shares of stock that you own at a set price with the intention of earning additional income.
When you write an option contract, you are obligated to sell the stock leveraged by that contract at the option's strike price to the purchaser of the contract when the option expires. It is called "covered" because you own the underlying stock.
For most options, a single contract represents 100 shares of underlying stock. There are some atypical options in which the underlying stock amount is some value other than 100 shares and may include other agreements such as a sum of money, but these options are beyond the scope of this discussion and are not included in the data provided.
The price of an option is given as the total value of the option divided by the underlying stock amount (i.e. 100). For example, an option price of $1.50 has a value of $150. A "Sell to Open" transaction for one call option contract priced at $1.50 would add $150 to your cash account (minus broker fees). Conversely, a "Buy to Close" transaction for the same call option priced at $1.50 would require $150 (plus broker fees) to cancel a call option.
How it works
Consider a scenario in which you own 1000 shares of Orange Computers Inc. (OCI). Let's assume you purchased the stock when it was $5/share. Now suppose it is trading considerably above that. You have already increased your value and wouldn't mind selling your position to take a profit. However, instead of just selling the stock you could sell call options on that stock. Normally your opening transaction is a buy order, but in this case your opening transaction is to sell.
| Expiration | Stock Last | Strike | Option Bid | Profit |
| June 2010 | $9.10 | $9.00 | $1.18 | $1.18 * 10 * 100 = $1,180 |
| June 2010 | $9.10 | $10.00 | $0.78 | $0.78 * 10 * 100 = $780 |
You would submit a "Sell to Open" order to create a short option position. The current market price is $9.10 and you think it is going to remain around this level for a short time, so you decide to sell 10 option contracts (each representing 100 shares of stock) for the $9 strike price. You received the $1,180 up front. That's cash in your account, but remember you've just given someone the right to buy 1000 shares from you at $9/share. As long as you keep those 1000 shares of OCI you're fine.
Owning those 1000 shares is what makes this strategy a "Covered Call." Otherwise your brokerage firm would make sure you had sufficient money in your margin account to cover the cost of buying 1000 share at the market price and selling them to the option buyer at $9/share.
The following are different ways in which your option contract may end:
- The market price falls below $9 and stays there until expiration. In that case you keep your 1000 shares of OCI and you get to keep the $1,180 premium you received and the call option expires worthless.
- The buyer exercises the option before expiration. It is not that common but it can happen. In that case your brokerage firm does an option assignment (for a fee that is) and sells your shares to that other person at the strike price. In this scenario, your account is credited $9,000 (minus fees) for the 1000 shares. You get to keep the $1,180 from the sale of the options.
- At expiration, OCI is still above $9. The option buyer's brokerage does an automatic assignment and your shares are sold at $9/share. You still get to keep the $1,180 from the sale of the options.
- Before expiration, you decide you want to keep your shares of OCI. Maybe your opinion has changed and you now believe it could go up to $15 or more and you don't want to miss out on that. You submit a "Buy to Close" order and buy back the options to close the contract. If the option is worth less than the original $1.18 you would realize a small profit by buying it back at a lower price. But you could also realize a loss if the price is above $1.18.
Advanced Covered Call Strategy
You may notice that Born To Sell provides several return columns in the data provided. This information is geared toward a strategy in which you do not already own shares in the underlying stock. Your intent would be to purchase shares and immediately sell call option contracts on those shares with the expectation of the options being exercised on or before expiration date.
For example, let's assume OCI is trading at $8.50/share and the call options with a strike price of $6.00/share has an option price of $3.00. It would cost you $850 to purchase 100 shares and you would obtain $300 for selling a call option contract. When the option was exercised, you would obtain $600 for the sale of your stock. You would loose $250 on the price of your stock, but you gained $300 in the sale of the call option for a net gain of $50 or 5.88% (i.e. 50/850 * 100) return on investment (ROI). That's a 5.88% ROI for a 4 week investment. Annualized, that is 70.56% ROI (i.e. 5.88 * 12 months) assuming you were able to make a similar trade each month for 12 months.
Note: this does not take into consideration the fees involved with the various transactions. Depending on the fees charged by your broker, your actual ROI will be lower and may even become negative.
The risks include either a loss of profit potential or a loss of capital. For example, if the stock zoomed way past $8.50/share, you still only make $50. You lose the profit you would have made had you not sold the call option. Conversely, if the stock drops way below $6.00/share, you may loose up to $550 (i.e. worst case scenario... the stock drops to $0.00/share). By selling the call option for $300, you essentially drop your cost per share down to $5.50/share. Your potential for loss is actually reduced by selling the call option as opposed to just owning the shares.
Additional Examples
For more covered call examples and info, please see Born To Sell's Covered Call Tutorial.