By Risk Academy
Covered Call
Learn how a Covered Call works, when investors and traders typically use this strategy, and understand its advantages and disadvantages. An educational guide by Risk Academy.
What Is a Covered Call Strategy?
Selling a covered call (covered call writing) always requires ownership of the underlying shares. This is why the short call position is called covered. It combines a long stock position with the sale of a call option against those shares.
There are two ways to use this strategy, each of which is suitable for different market conditions and investment objectives.
The first approach is not used at the same time the shares are purchased, but later, after the stock price has risen sufficiently to generate a profit.
You expect the stock price to continue rising over the long term, although you understand that a short-term profit-taking correction may begin in the near future. In other words, you take advantage of the cyclical nature of a bullish market by using temporary declines in the stock price.
Selling Covered Calls: An Investor's and Trader's Perspective
The diagram below illustrates one of the most common Covered Call scenarios used by long-term investors.
Figure 1. Covered Call strategy example: buying shares at $250 and selling a covered call at the $275 strike after the stock price rises.
The diagram above shows the stock price movement over approximately six months. At the beginning, the investor bought the shares at $250 (Point 1). About 1.5 to 2 months later, the stock price rose to $275 (Point 2).
On the one hand, the investor believes that the stock will continue to move higher during the year. On the other hand, he understands that a short-term profit-taking correction is possible, as many investors may decide to sell after the stock has already gained 11%.
At this point, he sells a call option (opens a short call position) with a $275 strike price and receives the option premium in his brokerage account.
Now let's look at the risk from two different points of view after the short call position has been opened.
The Investor's Point of View:
"What if I'm wrong and, after opening the short call position (selling the $275 call), the stock suddenly moves sharply higher? Let's say it rises to $300. In that case, the buyer of the call option may exercise the contract and require me to sell my shares at the strike price of $275. But I originally bought those shares for $250. That means I still make a $25 profit on the stock ($275 − $250), plus I keep the $10.50 option premium I received when I sold the call. So even in the worst-case scenario, I end up with a total profit of $35.50 ($25 + $10.50), although I no longer own the shares.
Yes, I temporarily lose the opportunity to benefit from any further increase in the stock price. But if the stock price stays unchanged or falls, I keep the option premium and I still own my shares."
The Trader's Point of View
"Let's assume I'm wrong and the stock continues to move higher. I sold an at-the-money call, which means it is in the 'dead zone.' As the stock price continues to rise by another $8–10, the option premium will increase by approximately 50%–70% of the stock's price movement (depending on implied volatility).
Since I received a $10.50 premium for selling the call, the upper boundary of the call's 'dead zone' will be at a stock price of $285.50 ($275 + $10.50). At that point, the call premium will be approximately $17.85 ($10.50 × 70% + $10.50).
In this case, I lose $7.35 on the call ($17.85 − $10.50), but the stock that I already own increases in value by $10.50.
Hmm... That means even though the stock continues to rise, my overall position still improves by $3.15 compared with my current position ($10.50 gain on the stock − $7.35 loss on the call). So, I'm really giving up only part of my future profit.
But if the stock price remains unchanged or declines, I keep the option premium, and I still own my shares."
Both points of view are absolutely correct. That is why many inexperienced individual investors are unnecessarily afraid of short option positions, believing that any type of options trading is extremely risky.
Covered Call Strategy in a Sideways Market
The second way of using a covered call is more commonly used by investors with a conservative approach.
It involves buying the shares and simultaneously opening a short call position. This approach is used when the option writer expects the underlying stock to trade in a sideways or moderately bullish trend over the short term (one to two months).
This strategy may be used to lock in profits, stabilize income in a relatively stable market, or reduce the overall cost basis of the stock investment.
Figure 2. Covered Call strategy example in a sideways market: buying shares at $30 and simultaneously selling an at-the-money (ATM) call with a $30 strike price. The $3.00 option premium extends the break-even point to $27 while limiting upside above the strike price.
The diagram below illustrates how the strategy works in a sideways market.
Although covered calls are often used as a portfolio protection strategy, helping traders deal with moderate declines in stock prices because the option premium offsets part of those losses, their protective nature is both an advantage and a disadvantage, since the upside profit potential is limited, especially when using this second approach.
The highest possible outcome of this strategy occurs if the stock price rises and is limited to the premium received from the short call.
Figure 3. Covered Call payoff at expiration: when the stock price rises to $35, both the covered call seller and the call buyer finish with a positive financial result, although their sources of profit are different.
Suppose an investor buys shares at $30 and simultaneously sells a call option with a $30 strike price, receiving an option premium of $3.00. If, on the expiration date, the stock price rises to $35, the call buyer will exercise the option and require the investor to sell the shares at the strike price of $30. In this case, the investor breaks even on the shares themselves, and the total profit is $3.00, which is the option premium received when the call was sold.
The financial result for the call buyer will be $2.00, since the buyer acquires the shares for $30, while they are worth $35, but has already paid a $3.00 premium ($35 − $30 − $3).
Here is an interesting paradox: in this example, both sides of the trade end up with a positive financial result.
Although the covered call strategy is primarily defensive in nature, it is important to remember that this protection works only within a certain price range and, for simplicity, is measured by the premium received from selling the call option.
If the stock price falls by $3.00, to $27, the investor's position in this example breaks even. The shares lose $3.00 in value ($27 − $30), but the $3.00 premium received from selling the $30 strike call offsets that loss.
Therefore:
Profit = $3.00 − $3.00 = $0.00
In practice, however, the option premium also contains time value (depending on how much time has passed), which results in an additional loss equal to the remaining time value of the option.
Thus, based on these examples, we can easily make one conclusion: all else being equal, the higher the premium received from the sold call, the greater the protective effect of the combination.
However, the option premium depends on the characteristics of the option. The deeper the option is in the money, the higher the premium
tends to be, because premiums of these options react almost 100% to changes in the price of the underlying stock.
This leads to another conclusion: the higher the premium of the sold call, the more limited the investor's ability to participate in further upside movement of the stock becomes.
Conservative vs Aggressive Covered Calls
Depending on which call option the investor decides to sell, the position may be considered either aggressive or conservative.
Selling an out-of-the-money (OTM) call creates a more aggressive position, while selling an in-the-money (ITM) call creates a more conservative one. This is because, in the first case, the investor receives less protection from the option premium against a possible decline in the stock price than in the second case. On the other hand, the investor has greater potential for a positive financial result if the stock price continues to rise.
As an example of different Covered Call approaches, let's consider a situation where AAPL shares are trading at $305, and a one-month call option with a $305 strike price is priced at $11.00.
Figure 4. Comparison of conservative and aggressive Covered Call strategies using at-the-money (ATM) and out-of-the-money (OTM) call options.
A more conservative investor buys the shares and opens a short position by selling an at-the-money call with a $305 strike price, thereby increasing the break-even zone but reducing the potential for further upside.
At the same time, a more aggressive investor also buys the shares but sells an out-of-the-money call with a $320 strike price. His break-even zone is much smaller, but the potential financial result is higher if the stock continues to rise.
As you can see, selling an out-of-the-money call offers greater upside potential if the stock price continues to increase, but it also exposes the investor to greater risk if the stock price declines.
The first investor could have made the position even more conservative by selling an in-the-money call with, say, a $300 strike price. The second investor, on the other hand, could have made the position even more aggressive by selling a call with a $325 strike price.
We encourage you to analyze both scenarios on your own and calculate the final financial result of each position using our example. You are welcome to send us your answers through our Contact page. We will be happy to review them and reply.
In conclusion:
The Covered Call strategy, used by many experienced investors, offers an opportunity to generate additional income from an investment portfolio while partially offsetting declines in the stock price through the premium received. At the same time, the investor voluntarily limits the potential profit if the stock continues to rise but is generally in a more favorable position than a buy-and-hold investor during moderately bearish market conditions.
The covered call strategy is not the only position that can be created using a call option. One of the most common situations in investment practice is when an investor buys a call option instead of the underlying shares because he does not have enough available cash at that moment.
A speculative trader may do exactly the same thing, even though he has enough money to buy the underlying shares. His motivation is different—to gain control of the same number of shares while committing significantly less capital.
At the beginning, however, both investors are in exactly the same position and therefore take on the same level of risk.
But that is another story.
Frequently Asked Questions
I don’t quite understand. How can I sell a call option if I don’t own one? In other words, how can I sell something I don’t have?
This is a very common question. When you sell a call option, you are not selling an option that was already sitting in your account. You are opening a new contract and receiving a premium for taking on an obligation. The buyer gets the right to buy the shares from you at the strike price, while you agree to sell those shares if the option is exercised. With a covered call, you already own the shares needed to meet that obligation.
If I sell a call option and receive the premium in my brokerage account, can I transfer that money to my bank account?
Usually, yes. The premium is credited to your brokerage account as soon as the trade is completed, and depending on your broker’s rules, it may be available for withdrawal. However, the call option is still open, so your obligation has not disappeared. You may later decide to buy the option back, and it could cost more than the premium you originally received.
What if I don’t want to give up my shares after selling a call option? Is there a way to keep them?
Yes. You can normally close the position before expiration by buying back the same call option. This removes your obligation to sell the shares. However, the price of the option may have changed, so buying it back could cost more or less than the premium you received. It is also important to remember that American-style options can sometimes be exercised before expiration, so waiting until the last moment may carry additional risk.
The Story Continues...
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