Covered Call Explained

A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If a trader buys the underlying instrument at the same time the trader sells the call, the strategy is often called a "buy-write" strategy. In equilibrium, the strategy has the same payoffs as writing a put option.

The long position in the underlying instrument is said to provide the "cover" as the shares can be delivered to the buyer of the call if the buyer decides to exercise.

Writing (i.e. selling) a call generates income in the form of the premium paid by the option buyer. And if the stock price remains stable or increases, then the writer will be able to keep this income as a profit, even though the profit may have been higher if no call were written. The risk of stock ownership is not eliminated. If the stock price declines, then the net position will likely lose money.[1]

Since in equilibrium the payoffs on the covered call position is the same as a short put position, the price (or premium) should be the same as the premium of the short put or naked put.

Trader A ("A") has 500 shares of XYZ stock, valued at $10,000. A sells (writes) 5 call option contracts, bought by Investor B ("B") (in the US, 1 option contract covers 100 shares) for $1500. This premium of $1500 covers a certain amount of decrease in the price of XYZ stock (i.e. only after the stock value has declined by more than $1500 would the owner of the stock, A, lose money overall). Losses cannot be prevented, but merely reduced in a covered call position. If the stock price drops, it will not make sense for the option buyer ("B") to exercise the option at the higher strike price since the stock can now be purchased cheaper at the market price, and A, the seller (writer), will keep the money paid on the premium of the option. Thus, A's loss is reduced from a maximum of $10000 to [$10000 - (premium)], or $8500.

This "protection" has its potential disadvantage if the price of the stock increases. If B exercises the option to buy, and the stock price has increased such that A's shares of XYZ are now worth more than $10,000 in the market, A (the option writer) will be forced to sell the stock below market price at expiration, or must buy back the calls at a price higher than A sold them for.

If, before expiration, the spot price does not reach the strike price, the investor might repeat the same process again if he believes that stock will either fall or be neutral.

A call option can be sold even if the option writer ("A") does not initially own the underlying stock, but is buying the stock at the same time. This is called a "buy write". If XYZ trades at $33 and $35 calls are priced at $1, then A can purchase 100 shares of XYZ for $3300 and write/sell one (100-share) call option for $100, for a net cost of only $3200. The $100 premium received for the call will cover a $1 decline in stock price. The break-even point of the transaction is $32/share. Upside potential is limited to $300, but this amounts to a return of almost 10%. (If the stock price rises to $35 or more, the call option holder will exercise the option and A's profit will be $35–32 = $3) If the stock price at expiry is below $35 but above $32, the call option will be allowed to expire, but A (the seller/writer) can still profit by selling the shares. Only if the price is below $32/share will A experience a loss.

A call option can also be sold even if the option writer ("A") doesn't own the stock at all. This is called a "naked call". It is more dangerous, as the option writer can later be forced to buy the stock at the then-current market price, then sell it immediately to the option owner at the low strike price (if the naked option is ever exercised).

This strategy is sometimes marketed as being "safe" or "conservative" and even "hedging risk" as it provides premium income, but its flaws have been well known at least since 1975 when Fischer Black published "Fact and Fantasy in the Use of Options". According to Reilly and Brown,"to be profitable, the covered call strategy requires that the investor guess correctly that share values will remain in a reasonably narrow band around their present levels."

This type of option is best used when the investor would like to generate income off a long position while the market is moving sideways. It allows an investor/writer to continue a buy-and-hold strategy to make money off a stock which is currently inactive in gains. The investor/writer must correctly guess that the stock won't make any gains within the time frame of the option; this is best done by writing an out-of-the-money option. A covered call doesn't have as much potential for reward as other types of options, thus the risk is also low.