What Is a Covered Call? Understanding the Risks Involved

Options trading has become more popular in recent years, with an increase in the number of online brokers and investment apps allowing the buying and selling of options contracts. A covered call is just one of many options strategies and one you should be aware of if you’re getting involved with options trading.

In this article, I’ll explain how covered calls work, the risks involved, and share a few online brokers that will let you employ a covered call strategy.

What Is an Options Contract?

An option is a financial transaction in which the investor purchases the ability – but not a requirement – to buy or sell an underlying security by a specific date.

Options trade in contracts and can be used with various securities, including stocks, bonds, commodities, indexes, and other assets. When an options contract is executed, it has three primary components: 

  • Expiration date: The date by which the option to buy or sell the security must be exercised. 
  • Strike price: The price level of the underlying security the option holder hopes to reach before profit is made.
  • Premium: This is the cost or value of the option. It is substantially lower than the current value of the underlying security and will represent the only money lost by the option holder if the option expires without being executed.

There are two basic types of options, call and put options. A call option gives the holder the right to buy a security, while a put option gives the holder the right to sell it. In either case, the individual executing the option contract does not need to own the underlying security.

What Is a Covered Call?

As you might expect, a covered call is based on a call option or the right to buy a security at a specific price. It differs from a regular call option in that the seller of the option owns the underlying securities in the trade.

For example, an investor who owns 100 shares of ABC Corporation, currently at $50 per share, might sell a call option for 100 shares of the same company at a price of $55 within 90 days. Because the investor holds an equivalent amount of stock to the option, the call is considered covered.

How to Use a Covered Call

Covered calls can be used either as a hedging strategy – to protect against a decline in the value of the securities owned – or as a way to generate an additional (small) profit on the position.

Let’s look at the downside protection factor first.

When an investor owns a security and then sells a call option against it, he is both long and short on the security. In that way, a call option is considered a neutral position.

He’s long because he owns the security. But he’s also short because he can gain if the security value falls (assuming the strike price is below the current price). But the downside protection is limited to the amount of the premium received for selling the call option, given that the loss on the long position will offset the gain on the option. 

On the profit side, the investor will generate a small profit from the premium on a call option sold to a holder. The investor will receive the premium even if the call option expires. 

But the investor can also receive a higher price for the stock if the covered call strike price is set above the current value. For example, if you hold a stock worth $40, and the call option has a strike price of $50, you will earn $10 per share if the buyer executes the option – plus the premium paid for the option.

In this way, selling a call option to a potential buyer can be a valuable strategy when holding a long-term position in a security. But it’s a recommended strategy for positions you hope will rise in the long term. That’s because it can go the wrong way, too.

Are There Any Risks with a Covered Call?

In a word, yes. There are several risks when using a covered call strategy.

1. Seller loses the right to participate in gains during the option term.

When an investor sells a covered call on her security position, and the buyer of the call exercises the option to buy, they forfeit the right to participate in gains in the price of that security.

For example, if the covered call is sold with the price of the security is $50 and rises to $60, the original owner will receive only the premium paid for the option. She will not participate in the $10 per share gain in the stock price unless the option buyer exercises his right to buy the stock, and only then if the sale is at a higher price. 

2. The buyer can execute the option to buy at any time.

The buyer of the covered call can exercise the option to purchase the underlying securities at any time, and at any price, before the expiration date. If the value of the stock is $50 at the time the covered call is sold, and the buyer exercises the right to purchase it at $55, the owner will be required by the option contract to complete the sale. 

Essentially, selling a call option on an investment position you hold effectively transfers control to the buyer of that option while the option is in force.

3. The potential loss on a covert call is 100%

In the unlikely event that the value of the underlying security goes to zero while the option contract is in force, the original owner will lose 100% of his investment if the call option buyer does not execute his option to purchase the stock before it goes all the way to zero.

This gets back to the lack of control factor. Since you’ve sold a call option on your investment, you will be unable to sell it to anyone other than the option holder until the option contract expires. 

If the stock price goes to zero and the buyer doesn’t exercise the option to purchase the stock, you’ll be out the entire position – less the premium you received for selling the call option.

The Best Use of Covered Calls

Covered calls are best used on long positions in underlying securities considered very stable. Though they can reduce the potential loss in a stock decline, they cannot eliminate it. The strength of the underlying security is always a factor with covered calls, just as it is with any type of investing.

Before selling a covered call on a position you own, you must be fully aware that you are giving up control of your investment. Your position can be liquidated at any time the buyer of the call decides to exercise the option to make the purchase, whether or not the sale price is a favorable one for you.

How Does a Covered Call Work?

As with all option types, there are various ways to write a covered call option.

As mentioned, a covered call is when you sell a call option on securities you already own. But it’s also possible to sell a covered call on shares you don’t own.

In a “buy-write” transaction, you’ll both purchase the underlying securities and sell a call option against them at the same time.

If you sell call options against securities you already own, it’s considered an “overwrite.” 

In any type of covered call, you must have a sufficient number of shares to match the call option on a share-for-share basis. But it’s also possible to sell multiple call options on the same security. For example, if you own 300 shares of AT&T stock, you can sell three separate call options of 100 shares each against that position.

It’s also important to understand the only revenue you are guaranteed to earn on a covered call is the premium. And that amount is notoriously small, particularly on high-priced stocks.

For example, the premium on the sale of a $100 stock may be just $1 (or less). If you sell a call option for 100 shares – or $10,000 in total – the premium will be just $100.

As already mentioned, once you sell a covered call, you may not participate in upside price gains unless the call option buyer buys the stock at a higher price than the value when the contract was initiated. But you can still lose money if the stock price falls.

Related: What is an Interval Fund?

Where to Invest in Options

Generally speaking, options trading is done in taxable brokerage accounts. It is possible to sell covered calls in a retirement account, particularly an IRA, but only if the trustee permits it. Meanwhile, there are more restrictions on options trading in retirement accounts than in taxable accounts.

If you are interested in options trading, including covered calls, consider the following online brokers:

All of these platforms offer options trading, as well as the ability to open an account with no money (though you will need funds to begin trading). They also offer commission-free options trading plus a small per-contract fee.

Whichever broker you choose, be sure you fully understand all the rules concerning options trades, especially covered calls. Though they’re generally the same from one firm to another, small variations may impact how you use them.

The Bottom Line on Covered Calls

As you can see, covered calls are a low profit strategy with substantial downside risk. For that reason, it should only be considered for use with securities with a relatively stable value and only when you are completely comfortable with the process and the risks involved.

Other Posts You May Enjoy:

HeyBenny Review: Maximize Your ESPP

Benny is a financial platform that helps employees of publicly traded companies maximize their Employee Stock Purchase Plan (ESPP) benefits. It advances the funds to employees with repayment plus fees due at the end of the participation period. But with fees and potential risks, is Benny worth the effort? And are there any alternatives? Find out in our Benny review.

8 Things to Know About Your ESPP

Employee stock purchase plans, or ESPPs, are a valuable employee benefit that some companies offer.
However, there are important rules, features, and tax implications to consider before signing up for your company's ESPP. Here's what you need to know.

About Kevin Mercadante

Since 2009, Kevin Mercadante has been sharing his journey from a washed-up mortgage loan officer emerging from the Financial Meltdown as a contract/self-employed "slash worker" – accountant/blogger/freelance blog writer – on OutofYourRut.com. He offers career strategies, from dealing with under-employment to transitioning into self-employment, and provides "Alt-retirement strategies" for the vast majority who won’t retire to the beach as millionaires.

He also frequently discusses the big-picture trends that are putting the squeeze on the bottom 90%, offering workarounds and expense cutting tips to help readers carve out more money to save in their budgets – a.k.a., breaking the "savings barrier" and transitioning from debtor to saver.

Kevin has a B.S. in Accounting and Finance from Montclair State University.

Opinions expressed here are the author's alone, not those of any bank or financial institution. This content has not been reviewed, approved or otherwise endorsed by any of these entities.

Subscribe
Notify of
guest

0 Comments
Inline Feedbacks
View all comments

As Seen In:

0
Would love your thoughts, please comment.x
()
x