Options trading, with its diverse range of strategies, offers a unique set of tools for traders to leverage market movements. One such strategy that is known for its potential to generate income and manage risk is the covered call.
Covered calls are a versatile options trading strategy that combines the benefits of stock ownership with the income potential of selling call options. This strategy is often used by investors looking to generate additional returns from their existing stock holdings, all while providing a level of downside protection.
This article provides a comprehensive overview of covered calls in options trading, including the pros, cons, and how to use the strategy.
What are Covered Calls?
A covered call is a method used for managing risks and trading options. In this strategy, an investor owns an asset, like a stock, and simultaneously sells a call option for that asset.
This is done with the expectation that the asset’s price will remain relatively stable.
The key benefit of using a covered call strategy is that the investor earns a guaranteed income, known as a premium, from selling the call option. If the price of the asset slightly goes up, the premium adds to the overall investment return.
On the other hand, if the price of the asset slightly decreases, the premium helps cushion the loss.
However, it’s not advisable to use a covered call strategy if you anticipate a significant increase in the asset’s value. This is because the potential profits are capped at the call option’s strike price.
Similarly, if the asset’s price experiences a substantial drop, the premium received may cover only a small portion of the losses.
READ: What You Need to Know About Long Call Options Strategy
How a Covered Call Works
In a covered call strategy, the trader sells the potential upside of a stock for a specific period in exchange for an option premium.
While selling call options can be risky because it exposes the seller to unlimited losses if the stock rises significantly, owning the underlying stock helps limit potential losses and allows for income generation.
Two scenarios can occur at the expiration of the call option:
- If the stock closes above the call’s strike price (the price at which the call becomes profitable), the call buyer buys the stock from the seller at the strike price. The call seller keeps the option premium.
- If the stock closes below the call’s strike price, the call seller retains both the stock and the option premium, and the call buyer’s option expires without value.
Let’s go through an example to illustrate how a covered call works.
Assume Stock X is trading at $20 per share, and a call option with a $20 strike price expiring in three months costs $1. The trader buys 100 shares of X for $2,000 and sells one call option, receiving a premium of $100.
Here’s the profit and loss breakdown for the covered call:
- Break-even point: The trader breaks even at $19 per share (stock price of $20 minus the $1 premium).
- Below $19: The trader incurs losses, offsetting the $1 premium received.
- At $20: The trader keeps the full $1 premium, making $100 at this stock price.
- Above $20: The trader’s gain is capped at $100. Although the short call loses $100 for every $1 increase in the stock price above $20, this loss is balanced by the stock’s gain, resulting in a maximum profit of $100 (the original premium).
While the covered call strategy limits potential upside to the option premium, it also mitigates risk by holding 100 shares of the stock for each contract sold.
In extreme cases where the stock rises significantly, the trader may miss out on potential profits. However, this approach serves as a hedge against losses.
In any covered call scenario, the maximum upside is the option premium, but losses can exceed this amount. If the stock falls drastically, the trader might only gain from the premium while experiencing a net loss on the stock.
For instance, making $100 on the option premium but losing $2,000 on the stock would result in a net loss of $1,900.
To manage losses, the trader could consider repurchasing the call option for a lower price and selling the stock position if needed.
Pros and cons Covered Calls
Pros
- Covered calls can serve as a reliable way to earn passive income. Investors receive a premium for selling the call option, which can supplement their overall income from dividends or interest payments.
- By selling a call option, investors can limit potential losses if the price of the underlying asset decreases. The premium received from selling the call option helps offset some of the potential losses.
- Covered calls can be applied to various underlying assets, including individual stocks, ETFs, and mutual funds. This flexibility allows investors to customize their strategy based on their specific investment goals and risk tolerance.
Cons
- Selling a call option means giving up some potential gains if the price of the underlying asset significantly increases. The investor is obliged to sell the asset at the strike price, even if the market price is higher.
- Covered calls come with limited upside potential, as investors are obligated to sell the asset at the strike price if the option is exercised. This implies missing out on potential gains if the underlying asset’s price rises significantly.
- Covered calls involve a complex strategy. Investors need a solid understanding of options trading and associated risks before adopting them as a strategy for generating passive income.
READ: A Beginner’s Guide to Long Put Option Strategy
How to Use Covered Call Strategy
Step #1: Select a stable stock for your covered call
Let’s consider a low-beta stock like Starbucks as an example. Our goal here is to choose a stock with low volatility.
Source: Trading Strategy Guides
Starbucks is the kind of low-volatile stock suitable for the poor man’s covered call strategy. A stock’s beta of 3 implies it is three times more volatile than the market.
While a 10% market gain could yield a remarkable 30% return, a 10% market decline would result in a significant 30% loss, something we don’t want. As a trader, safeguarding your capital is paramount, making the poor man’s covered call strategy a favorable choice.
Step #2: Buy an in-the-money call option
Instead of investing in 100 Starbucks shares, requiring a minimum capital of $7,013 plus commissions, the poor man’s covered call strategy allows you to buy an option contract equivalent to 100 shares, such as the $62.50 strike.
Source: Trading Strategy Guides
An effective trading approach is to use Long-Term Equity Anticipation Securities (LEAPS), options with an expiration date exceeding one year.
Assuming we buy the $62.50 strike option for $13.00, we only need to set aside $1,300 instead of $7,013, thereby freeing up $5,713 for other uses. This offers substantial earnings with comparatively lower risk.
For instance, buying 100 shares of a $100 stock could generate approximately $118 per week, resulting in a 1% weekly return, compounded to over 100% annually.
On the other hand, the poor man’s covered call with a deep-in-the-money call costing $2,800 instead of $10,000 enables a potential 4% weekly return, compounding to about a 143% return on investment.
While using options involves increased risk due to higher volatility, practice, and training can mitigate these risks.
Step #3: Sell an out-of-the-money call option
Complete the strategy by selling an out-of-the-money call option against the in-the-money call option. For example, selling the $75.00 strike for $1.5 would result in a $150 premium.
Source: Trading Strategy Guides
The total cost of constructing this option spread is $1,300 – $150 = $1,150, further reducing our overall costs.
READ: An in-Depth Guide to Diagonal Spread Options Strategy
Conclusion
Covered calls in options trading offer investors a strategic approach to generating income and managing risk in their portfolios.
By combining stock ownership with the sale of call options, traders can leverage market volatility to their advantage.
The covered call strategy provides a balance between earning premium income and potentially sacrificing some upside potential. It’s crucial for investors to carefully assess their risk tolerance, market outlook, and individual stock positions before implementing covered calls.
While this strategy can enhance overall portfolio returns, it requires a thorough understanding of options and diligent monitoring of market conditions.
As with any investment strategy, traders must stay informed, adapt to changing market conditions, and continually refine their approach to maximize the benefits of covered calls in their trading activities.
