Selling Covered Calls: Definition, Strategy & Risks
Combining options and stock positions can create unique investment exposure for investors. The practice of selling (writing) call options while also owning the underlying stock is known as selling covered calls. Read below to learn more about the appeal of covered calls, how investors can go about selling them.
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What Is a Call Option?
There are 2 types of options securities available on listed stocks: call options and put options. Call options give the owner the right to buy shares of an underlying stock at a designated price (known as the strike price, or exercise price) up until the expiration date, while put options give the owner the right to sell shares of an underlying stock at the strike price prior to expiration.
Options are classified as derivatives because their value is tied to the value of a separate underlying security. That means they can be used by themselves to speculate on that security's direction, or they can be used in conjunction with their underlying securities to provide benefits such as incremental income, which would minimize the size of the loss should the stock price decline, and reduced volatility. Combining a long stock position with the sale of call options on that stock is a well-established strategy that offers those benefits.
A call option contract is identified by its:
- Strike price
- Expiration date
- Underlying security
For example, an investor might purchase a call option for XYZ stock in January of a given year. If it had a strike price of $125 and an expiration date of March 18, the option would be identified as:
XYZ March 18 125 Call
This hypothetical call option would give its holder the right to buy 100 shares (standard option contracts all represent 100 shares) of XYZ at a price of $125 per share. This right persists until March 18th. If we assume that XYZ stock was trading at around $120 at the time of the call option transaction, and the call option was priced at $3, this call option would cost the buyer $300 (as it represents 100 shares).
$3 x 100 = $300
That $300 (known as the option premium) would be credited to the seller, less any commissions or exchange fees for the transaction.
How Call Options Work For Sellers
Since call options give their holders the right to buy the underlying stock at the designated strike price anytime prior to expiration, regardless of where it might be trading in the market, sellers of call options therefore absorb the obligation to sell the stock to the buyer at that strike price if the buyer chooses to exercise the option.
The seller gets paid by the buyer (the option premium) for taking on that obligation and limiting their upside opportunity on the stock for the duration of the option.
Uncovered Call Sellers
Those who sell calls without owning the underlying stock ("uncovered call" sellers) are essentially subjecting themselves to unlimited upside risk, since they would have to deliver the stock if the option is exercised and that could mean having to purchase it at some sky-high price to meet that obligation.
Note: Brokers restrict who is allowed to sell uncovered calls and require hefty margin requirements as collateral accordingly.
What Is a Covered Call?
On the other hand, those who sell calls and do own the underlying shares are "covered" in that they can simply deliver the shares they own to meet an exercise obligation. Covered call sellers (writers) are thus in a substantially different position than uncovered call sellers.
By owning the underlying stock, the covered call writer ensures that they can meet the obligation of an option exercise, wherever the price of the stock may go. There is no longer an unlimited upside risk and no margin required from covered call writers (as long as they don't sell more than one option contract for every 100 shares owned.)
Covered call writing is therefore an investment strategy that combines owning stock with selling covered calls. The covered call writer receives a premium from the call option buyer in return for the obligation to sell the stock at the strike price anytime up to the option's expiration. In this manner, the covered call writer has essentially traded some of the potential upside on the stock for a fixed return in the form of an option premium instead.
Covered call writers incur an opportunity risk on the upside (the risk that the stock will go up and they will not fully participate in that gain), but because covered call writing takes in money for that obligation, it actually offsets downside losses should the stock price fall, and produces a fixed return for the period. For these reasons, institutional investors such as pension plans and endowments have been using covered call writing strategies for decades.
Key Takeaway: Uncovered call writers incur unlimited upside risk. Covered call writers who already hold the underlying stock will actually reduce the potential losses on the stock on the basis of receiving option premiums.
Call Buyer vs. Call Seller: A Comparison
The call buyer in the above example stands to benefit should XYZ rise in price above $125. At $3 for the call in the above example, the call offers more than 40:1 potential leverage over buying the stock, but can also expire totally worthless. If XYZ shares close at $137 on the option expiration date, the call option would have an intrinsic value of $12 per share, or $1,200 per contract.
$137 - $125 = $12 x 100 shares = $1,200
The buyer could realize a profit of $900 due to the rise in the stock price.
$1,200 option value - $300 initial cost = $900
If the stock closes at less than $125 per share, the call will be worthless and the buyer will lose their $300 investment entirely.
The buyer is essentially paying $3 for the right to all value in the stock above $125 at expiration. However, they need to recover their $3 cost before actually making a profit, so they will profit only when the stock is above $128 ($125 + $3) at expiration. For prices below $128, the buyer will realize a loss.
A call writer is essentially taking the other side of this gamble. A seller who is "covered" has two related positions: long stock and a short call option. The premium of $300 from the buyer is immediately realized by the seller in the initial transaction, regardless of what happens at expiration. This is their compensation for agreeing to give up any appreciation in the stock above $125 at expiration.
3 Scenarios for the Covered Call Writer
Once a covered call writer sells an option on shares held, there are three general scenarios that can occur:
- The stock price remains at or below the strike price of the option at expiration: In this case, the option will expire worthless and the call writer will have no further obligations. The premium received from the sale of the option serves as an additional income to the call writer, who could write another call option if they so choose.
- The stock is above the strike price at expiration: Then the call writer has taken no action, the option will be exercised and the stock automatically sold.
- The call writer repurchases the call option to close the position prior to expiration: This may result in a gain or loss on the option depending on whether the stock has moved up or down since initially selling it and how much time remains until expiration.
A covered call writer is never locked-in, and always has the ability to unwind the position to remove any further obligations should their outlook change on the underlying stock or on the strategy itself.
How To Sell Covered Calls
The process for selling covered calls assumes that the investor has a brokerage account with options approvals and the necessary minimum $2,000 in equity.
- The investor has (or buys) 100 shares of a stock.
- The investor selects a call option that represents those shares at a desired strike price and expiration date and sells that call option contract. (Since the investor is opening an option position by selling it, their position is said to be "short", rather than "long".)
- The option seller may choose any strike price or expiration date that suits their approach and outlook for the stock. In general, selling higher strike calls brings in less options premium, but allows the stock to appreciate more before reaching the strike price and risk being called away. Selling calls with lower strike prices, on the other hand, brings in greater income, but increases the risk of losing the stock to an exercise. Investors must decide how much potential upside appreciation they're willing to forego for a fixed return during the period.
- The option writer also must decide on an option expiration date. The further away the expiration date, the more premium a call writer will receive, but the more time they remain obligated to sell the stock at the strike price. Also, time value in option premiums is not related to time in linear fashion. That means going out twice as far into the future yields something less than twice the option premium.
Note: Most brokerage firms will allow covered call writing in cash or margin accounts and in IRAs as well.
Bottom Line
Covered call writing is a widely practiced investment strategy that combines stock ownership with the selling of call options on those shares. The strategy, which can be implemented in different ways to suit an investor's holdings, risk tolerance, and objectives, offers unique benefits that include generating income, lowering the price volatility of stock holdings, and hedging downside risks. In return, covered call writers agree to sell their shares at a price specified by the option, which means they forgo some of the upside potential in their stock(s) on which they're written call options. Covered call writers could be required to deliver their stock to another party as a result of an option exercise. For investors willing to take the time to learn and implement covered call writing in their portfolios, the wide array of listed options available on many stocks provides many ways to take advantage of the strategy.
This article was written by
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