What Are Covered Calls? Benefits and Risks

Covered calls are a popular options strategy that investors use to generate additional income from their existing stock holdings. The strategy is often employed in markets where investors want to create an additional stream of cash flow from the stocks they already own. However, like any investment strategy, covered calls come with their own set of risks and rewards. Understanding how covered calls work, their benefits, and the potential downsides is crucial for any investor considering adding them to their portfolio.

In this comprehensive guide, we will explore covered calls in detail, discussing how they function, their potential advantages, and the risks that come with the strategy. By the end of this article, you’ll have a well-rounded understanding of whether covered calls might be a good fit for your investing strategy.

What Are Covered Calls?

A covered call is an options trading strategy where an investor holds a long position in a stock or another asset and simultaneously sells (writes) call options on the same asset. The term “covered” refers to the fact that the investor already owns the underlying stock, providing “coverage” for the options contract. This strategy involves selling a call option to another investor while retaining ownership of the underlying stock.

When an investor writes a covered call, they agree to sell their shares of stock to the buyer of the call option at a predetermined price (called the “strike price”) by a specific expiration date. In exchange for this agreement, the seller of the call receives a premium — a payment made by the buyer for the right, but not the obligation, to buy the stock at the strike price.

The key feature of a covered call is that it involves holding the stock in question, meaning that the investor is “covered” in case the stock price rises above the strike price. This differs from an uncovered or “naked” call, where the seller doesn't own the underlying stock and may be forced to buy the stock at the market price if the option is exercised.

How Covered Calls Work

To fully understand how covered calls work, it’s essential to break down the components of the trade:

1. The Stock (Underlying Asset): To sell a covered call, you must first own shares of stock or another underlying asset. The number of options contracts you can sell is typically determined by the number of shares you own, as each contract represents 100 shares of the underlying stock.
2. The Call Option: A call option gives the buyer the right (but not the obligation) to buy the underlying asset at a predetermined price (the strike price) before the option’s expiration date. If the stock price rises above the strike price, the buyer may choose to exercise the option and buy the stock at the agreed price.
3. Premium: The investor writing the covered call receives a premium, which is the price paid by the buyer of the call option. This premium is the income generated from the strategy. The amount of the premium depends on several factors, including the strike price, the time until expiration, and the volatility of the underlying stock.
4. Strike Price: The strike price is the price at which the call option holder can buy the underlying stock. When selecting a strike price, the seller will typically choose one that is above the current market price of the stock (an “out-of-the-money” call) or close to the current market price (an “at-the-money” call).
5. Expiration Date: Options have an expiration date, and the seller is obligated to sell the stock at the strike price if the buyer exercises the option before that date. The expiration can range from days to months, depending on the terms of the option.

Here’s an example of how a covered call works:

• Suppose an investor owns 100 shares of XYZ Corporation, which is currently trading at $50 per share.
• The investor sells a covered call option with a strike price of $55 that expires in one month.
• The buyer of the call option pays the investor a premium of $2 per share, or $200 in total.
• If the stock price rises above $55, the buyer may exercise the option, and the investor must sell their shares at $55.
• If the stock price remains below $55, the option expires worthless, and the investor keeps their shares and the $200 premium.

Benefits of Covered Calls

Covered calls offer several advantages that make them an attractive strategy for many investors. Some of the primary benefits include:

1. Generate Additional Income

One of the main reasons investors use covered calls is to generate additional income from their existing stock holdings. By selling call options, the investor collects premiums, which can provide a steady stream of income. This can be particularly useful in markets where stock prices are relatively flat or rising slowly, as the option premiums can enhance the overall return on investment.

2. Downside Protection

While a covered call strategy does not offer complete downside protection, the premium received from selling the call option provides a buffer against potential losses. For example, if the stock price falls, the premium received from the call option reduces the effective loss on the stock position. However, it is important to note that the investor will still experience a loss if the stock price drops significantly, just with a smaller net loss due to the premium income.

3. Suitable for Neutral or Moderately Bullish Market Conditions

Covered calls are ideal for investors who believe that the underlying stock will not rise significantly in price. If an investor expects the stock to stay flat or appreciate only modestly, a covered call allows them to capitalize on the sideways movement by collecting premiums without giving up much potential upside.

4. Improved Risk-Adjusted Return

By incorporating covered calls into an investment portfolio, investors can improve their overall risk-adjusted returns. The premium income received from writing call options can enhance total returns while helping to offset the downside risk of owning individual stocks.

5. Flexibility

Covered calls offer flexibility in terms of how investors choose to implement the strategy. They can choose different strike prices and expiration dates based on their outlook for the stock and the level of income they want to generate. This flexibility allows the strategy to be tailored to individual preferences and market conditions.

Risks of Covered Calls

While covered calls provide income and downside protection, there are also risks associated with this strategy. It’s important to understand these risks before deciding to use covered calls as part of your investment approach.

1. Limited Upside Potential

One of the most significant downsides of selling covered calls is that it limits the potential upside of the underlying stock. If the stock rises above the strike price and the option is exercised, the investor must sell the shares, missing out on any gains beyond that point. For example, if the stock price increases to $70 but the strike price was $55, the investor will still only receive $55 per share, even though the stock has risen well above that price.

2. Missed Opportunity in Bull Markets

In strong bull markets, stocks can rise rapidly, and the investor will be forced to sell their shares at the strike price, which may be significantly lower than the market price. This means that investors who sell covered calls might miss out on substantial gains during a market rally, especially if the strike price was set too low.

3. Continued Ownership of the Stock

While covered calls provide income from premiums, they still require the investor to own the underlying stock. This means that the investor is still exposed to the risks of holding the stock, including volatility and price declines. If the stock experiences a significant downturn, the premium income may not be enough to offset the losses.

4. Obligation to Sell

If the buyer of the call option exercises their right to buy the stock, the seller of the covered call is obligated to sell their shares at the strike price. This may not always align with the investor’s preferences, particularly if they would like to hold onto the stock for long-term growth or dividend income.

5. Limited Protection in Bear Markets

While the premium income from selling a covered call provides some protection in a falling market, it does not offer significant downside protection. In a bear market, the stock’s price may decline significantly, and the premium income may not be sufficient to offset the loss.

Additional Insights: When Covered Calls Are a Good Fit

In many cases, covered calls can be a useful strategy when the investor’s market outlook aligns with certain conditions. For example, an investor holding a large number of shares in a stable, dividend-paying company may not expect significant growth in the near term. By selling covered calls, they can collect premiums while waiting for the stock price to rise. This situation is common with companies that have steady earnings growth but are not experiencing explosive price movements.

Moreover, covered calls can work well for investors who are willing to forgo some capital appreciation in exchange for steady income. For instance, someone who has long-term holdings in stocks might use covered calls to increase their portfolio's yield while potentially mitigating some of the risks associated with volatility.

It’s also important to remember that covered calls can serve as an effective way to mitigate the impact of inflation on a portfolio. In environments where inflation is high and bond yields are low, the premium received from writing covered calls may help keep returns on par with inflation, especially in periods of stagnant stock growth.

When Not to Use Covered Calls

On the other hand, covered calls are not suitable in all market environments. In particular, investors with a bullish outlook on their stocks may find this strategy limiting. If an investor expects a stock to soar in price, the opportunity cost of selling a call may be too high. For example, if an investor owns a stock that is about to release a new product or report earnings and expects a significant price jump, selling a call may limit their profit potential.

Additionally, for those holding volatile stocks, covered calls may not be the best strategy. Volatile stocks can experience large price swings, and the premium received may not compensate for the risk of losing out on a big upside move or the difficulty in predicting where the stock price will end up at expiration.

Key Considerations Before Writing Covered Calls

Before implementing a covered call strategy, investors should consider the following:

• Market Outlook: A covered call strategy works best in a market where the investor expects limited upside or flat performance for the stock. If you believe the stock will rise sharply, this strategy may not be ideal.
• Stock Selection: Ideally, the stock selected for a covered call should be one that the investor is willing to sell if necessary. It is important to choose stocks with moderate volatility and stable performance.
• Strike Price and Expiration Date: Careful consideration should be given to the strike price and expiration date of the options sold. A higher strike price allows for more upside potential but typically results in a smaller premium. The expiration date should align with the investor's view on the stock’s price movement.

FAQs 

1. How does a covered call work?

A covered call works by allowing an investor to sell a call option on a stock that they already own. The investor receives a premium for writing the option, and if the stock price rises above the strike price, the option holder may exercise the option, forcing the seller to sell the stock at the agreed price. If the stock price remains below the strike price, the seller keeps both the premium and the shares.

2. Can you ever lose money on a covered call?

Yes, it is possible to lose money on a covered call. If the stock price falls significantly, the loss on the stock holding may exceed the premium income from the call option. However, the premium provides some downside protection, reducing the total loss.

3. Do you need to own 100 shares to sell covered calls?

Typically, each option contract represents 100 shares of stock. Therefore, to sell one covered call, an investor must own at least 100 shares of the underlying stock. Multiple contracts can be sold if the investor owns a corresponding number of shares (e.g., 200 shares for two contracts).

4. What happens if a covered call expires out-of-the-money?

If a covered call expires out-of-the-money (meaning the stock price is below the strike price), the option expires worthless, and the investor keeps both their shares and the premium received for selling the option. The investor can then choose to sell another call or hold onto the stock.