Options Strategy: The Covered Call

The covered call is one of the most straightforward and widely used options strategies for investors who want to pursue an income goal to potentially enhance returns. In fact, traders and investors with accounts approved for options trading may even consider covered calls in their individual retirement accounts (IRAs). While the strategy is straightforward, there are important things to know before diving in.

A covered call is typically a neutral-to-bullish options strategy created by selling an out-of-the-money (OTM) or at-the-money (ATM) call option against 100 shares of stock that a trader already owns (hence the "covered" description).

By selling a call, the trader collects premium upfront in exchange for agreeing to sell their shares at the contract's strike price if the call option is assigned.

Depending on how the trade progresses and whether a trader wants to sell or hold the underlying stock, some traders will buy the call back to close their position prior to expiration or roll it to a later expiration date.

If the covered call expires OTM, the trader keeps the 100 shares and the options premium collected. If the stock moves above the call's strike price, the call option is in the money (ITM) and will likely be assigned, though not guaranteed, requiring the covered call holder to deliver the underlying shares at the strike price.

If assignment isn't the desired outcome, a trader has some choices to make before expiration. They can look to maybe roll the call to a later expiration date—sometimes at a higher strike price—or potentially buy the short call back before it expires, possibly taking a loss on the call but continuing to keep the stock.

It's important to note that short options can be assigned at any time before expiration, regardless of the amount by which they're ITM when using American-style options. An ITM option has a higher risk of being assigned early. Once assigned, it's too late to close the call and the stock will be called away, which caps any potential profits above the strike price.

From the Analyze tab, enter the stock symbol, expand the Option Chain, and analyze the various options expirations and the out-of-the-money call options within the expirations.

Traditionally, the covered call strategy has been used for one of two primary goals:

1. Generate income
2. Offset a portion of a stock's potential decline

Let's look at two examples and explore how the strategy works in each case.

Offsetting a portion of a stock price's drop. A covered call can compensate to some degree if the stock price drops, the short call expires OTM, and the premium received from the short call offsets the long stock's loss. But if the stock drops more than the premium received from selling the call option, the covered call strategy begins to lose money. In fact, the covered call's maximum possible loss is the price at which the stock was purchased minus the credit(s) from the short calls plus transaction fees. The bottom line? If the stock price tanks, the short call offers minimal protection.

Notice that the outcome of a covered call often hinges on whether the trader gets assigned, so they need to strategically select the strike price.

If a stock's been beaten down and a trader thinks a rally is in order, they might decide to forgo the covered call. Even though they may be able to buy back the short call to close it before expiration (or possibly make an adjustment), if they think the stock's ready for a big move to the upside, it might be better to hold shares rather than risk losing them with a covered call. Conversely, if the underlying stock had a big run and a trader thinks the rally is out of steam, selling a covered call may be a consideration. 

Once a trader is ready, what strike should they choose? There's no right answer to this, but here are some ideas to consider:

• Select a strike where they're comfortable selling the stock. 
• Consider a strike price where there's probable resistance on the chart. 
• Evaluate a strike based on its probability of being ITM at expiration by looking at the delta⁶ of the option. For example, a call with a 0.25 delta is read by some traders to imply there's a 25% chance of it being above the strike and a 75% chance of it being below the strike at expiration. It's not exact, of course, but some consider delta to be a rough estimate of the probability of an option expiring ITM. (Understand that probability calculations are hypothetical and are based on theoretical pricing models. These models use variables that are subject to continuous change.) 

Because a trader selling a covered call might be giving up the potential for additional profits if stock XYZ rises above the strike price, the strategy is not appropriate if one thinks the stock has potential for significant gains in the near term. But in markets where the trader expects movement more incrementally, this strategy could be useful. Keep in mind, a market that was moving incrementally in the past won't necessarily continue to do so in the future. Also, if the stock goes up, the call option will typically increase in value as well, and the losses on the short call will offset some or all gains on the stock. But that's only one feature of this options-based income strategy. 

What happens when a trader holds a covered call until expiration? 

First, if the stock price is above the strike price, the stock will likely be called away, perhaps netting an overall profit if the strike price is higher than the break-even point, which (excluding transaction fees) is the stock's purchase price minus the premium from selling the call. 

Second, if the stock price moves up near, but below, the strike price at expiration, the trader would likely get to keep the stock as well as the full premium of the now-worthless option. 

Third, if the stock falls, the call will likely expire worthless if it is OTM, and the position might show a gain or loss at expiration, depending on whether the premium for selling the call is enough to offset the loss in the stock. The major downside to the trader here is that the trader is typically stuck holding the stock position as it declines. To a long-term investor, this may be a minor consideration, but to a shorter-term trader it could represent a real inconvenience. 

A covered call has some limits because the profits from the stock are capped at the strike price of the option. Another downside is the chance of losing a stock a trader wanted to keep. Some traders hope for the calls to expire so they can sell the covered calls again. Others are concerned that if they sell calls and the stock runs up dramatically, they could miss the up move. Covered calls, like all trades, are a study in risk versus return. With the right knowledge and tools at one's fingertips, traders could consider covered call options strategies to potentially generate income.