Covered Calls Summary
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Selling covered calls is a popular options strategy for generating income by collecting options premiums.
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A covered call combines shares you own with a call option you sell against those shares. A standard U.S. equity option usually represents 100 shares, although adjusted contracts can have different deliverables.
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The strategy works best if you expect the stock to stay within a pretty tight range of prices.
Quick Options Recap
A call option gives its buyer the right, but not the obligation, to buy the underlying shares at the strike price on or before expiration, depending on the option's exercise style. A put gives the right to sell. This example uses a stock at $50 and a call with a $52 strike expiring in two weeks.
Why Options?
Why would I want to have the right to buy a stock for $52 in two weeks if it’s trading at $50 right now? There are many reasons and cases for buying an options contract but one simple answer is that options require less cash upfront than buying the stock outright. Let’s say I think this stock is going to go up to $55 in the next two weeks, I can go buy the stock and spend $50 to make $5 in two weeks by holding the stock. I need to put down $50 to make my bet.
Suppose a call has a $52 strike and costs $1 per share. If the stock is $55 at expiration, its intrinsic value is $3 per share. After subtracting the $1 premium, the buyer's profit is $2 per share, or $200 for a standard 100-share contract, before fees and taxes.
Two Notes on Options
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Options pricing is very complicated and this is a very simplified example.
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One standard 100-share contract at a quoted premium of $1 per share costs $100. In this example, the $300 intrinsic value is not the profit: the net profit is $200 after the premium.
Buyer vs Seller
An assigned writer of a physically settled stock call must deliver the contract's shares at the strike price. The writer retains the premium. The option position's result and the stock position's result must be considered together; this is not simply a cash payment of the price difference.
But, say our bet was wrong and the stock stayed at $50 in two weeks from now, then I wouldn’t exercise my option to buy at $52 and the contract would just expire worthless. The seller of the option sold us the contract for $1 and gets to pocket that dollar if the contract expires worthless. Now you see how someone could make money selling options contracts.
Covered Calls
Suppose we buy 100 shares at $50 each and sell one standard call with a $52 strike for $1 per share. We collect $100 in premium. The shares cover our delivery obligation if the call is assigned. An American-style call can be exercised before expiration, so its writer can face early assignment.
Like I said earlier about the seller, which is us now, we can make or lose money on this deal, depending on where the stock price is when the contract expires. We’ll give two simple example scenarios for the stock price at expiration.
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$50: The stock stays at $50 and the contract expires worthless
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We keep the $100 and pay out nothing. $100 profit
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We get to keep our 100 shares
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$55: The stock goes to $55 and the buyer exercises their option
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We collected $100, but we also owe the option buyer the shares at $52
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Since we own 100 shares of the stock we can just sell the shares to the buyer at $52. (Remember: when we sold the contract two weeks ago the stock was at $50 so selling it at $52 is still profitable)
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The Stock Can Still Lose Value
Receiving a premium does not guarantee a profit. If the stock falls to $45 at expiration and the call expires worthless, the shares have lost $500. The $100 premium reduces the combined loss to $400, before fees and taxes.
Not So Fast
While it seems very simple, we need to account for our old friend from economics class, the opportunity cost. The opportunity cost is loosely defined as the loss of potential gain from a different alternative. In this case, although we made $100 in premium and $200 from selling the stock ($50 to $52), the stock actually went up to $55 and if we had just held it we would have profited $500 ($50 to $55) from the surge in price.
What’s Going on Here?
The premium provides only limited downside protection. In this example, the break-even price at expiration is $49. If the shares become worthless, the combined loss is $4,900. The maximum profit is $300: $200 from selling shares at the $52 strike plus the $100 premium. Selling the call caps the upside while leaving substantial stock risk.
Okay, So?
So, if you understand the above, you’ll realize that the covered call strategy is best suited for an investor when they feel relatively neutral about a stock for the term of the contract, meaning they don’t believe the stock will surge or plummet by a lot over that period of time. If you have a stock at $50 and you believe it will still be at $50 in two weeks, then selling a covered call with a strike price above the current price will allow you to make money even if the stock doesn’t move.
Repeating the Strategy
Selling another call creates a new position with its own premium, strike, expiration, and assignment risk. Premiums are not fixed, and a call expiring worthless does not erase a loss on the shares. If shares are called away, continuing the strategy may require buying shares again. Evaluate the combined stock and option results rather than counting premiums alone.
Disclaimer: This strategy is not risk-free and we are not making any investment recommendation here.
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