Covered Calls

Owning stocks is risky. Writing calls on that stock mitigates the risk by allowing the call writer to collect call premiums and any dividends based on the stock ownership, thus reducing the volatility of ownership. A stock owner who writes covered calls will generally do better than one who only owns the stock if the market rises slightly, remains flat, or even declines. Only if the stock price zooms higher than the strike price of the call will the stock owner do better than the covered call writer. However, a covered call should not be written if the stock is expected to decline substantially, especially if there is no short-term expectation of a recovery. Therefore, the covered call writer should be slightly bullish or neutral on the underlying stock, since the stock must be held to maintain the cover.

The objectives of covered call writing are to maximize the income from the underlying asset — through option premiums, dividend income, and stock ownership — while providing downside protection, which is usually accomplished by writing calls that are near the money, either slightly in- or out-of-the-money.

A call gives the owner the right, but not the obligation, to buy a particular asset, the underlier, at a set price called the strike price. A call on a particular stock gives the owner the right to purchase 100 shares of that stock at the strike price. A call is created by the call writer who agrees to supply the underlier to the call holder for the strike price. So a call on Google with an $800 strike price gives the call holder the right to buy 100 shares of Google from the call writer for $80,000.

A covered call is issued by a call writer who owns the underlying asset; otherwise, the call writer would be creating a naked call. If the call is exercised, then the naked call writer must buy the stock on the open market, incurring substantial risk. The covered call writer avoids the risk by already owning the underlying asset or by purchasing the asset at the same time that the call is written. Another possibility is that the covered call writer can also own a call option that can be exercised to fulfill the written call. So a covered call on Google would be issued by a writer who either owns 100 shares of Google stock or owns a call for Google stock, presumably for a strike price lower than the written call.

A buy-write is like a covered call, but the stock is bought when the call is sold. Often, this is done simply to earn the call premium. For instance, 100 shares of Apple, Inc. could be purchased for $102.13 on 8/27/2014 while the September call with a strike of $103 could be sold for $2 per share. If the stock gets called away, that still leaves a $200 profit for the call contract plus $87 for the stock for a net of $287, earning a 2.8% return on the $10,213 investment in less than a month, equal to an annualized return of 33.7%. However, there is risk that AAPL stock will decline in the meantime. Some trading platforms offer the buy-write strategy as a single selection, where a limit price can be specified that equals the difference between the stock price and the call premium. For instance, a limit order can be set for $45 that will simultaneously buy the stock and sell the call such that the net price will be $45. So the order will be executed if the stock price is $51 and the call premium is $6, because the difference will equal the limit price of $45.

Covered Call Strategy

Graph of a covered call position.

Although the call premium is the most that can be made by writing the call, greater profits can be earned by setting the strike price of the call above the writer's cost basis in the stock so that an additional profit will be made if the stock is called away. Moreover, if the calls are not exercised, then additional call premiums can be collected by writing new calls for succeeding expiration dates, after the expiration of the old calls, while continuing to collect any dividends from the underlying stock, a strategy that can continue month after month, as long as the calls are not exercised. If the calls are exercised, then an additional profit can be made as long as the strike price was above the cost basis in the stock. If the call is exercised, then the total payoff received by the call writer is:

However, the maximum profit will depend on the call writer's cost basis in the stock plus any dividends received during the holding period:

Example: if you had sold calls for $12 a share on stock that you own, for which you paid $10 per share, and if you received $2 for the call premium on each share and you received $1 in dividends, then your net profit will be $5 per share minus transaction costs.

Example: How to Calculate the Downside Breakeven Point

A call, like other options, has both intrinsic and time value. The intrinsic value of the call is the amount by which the stock price exceeds the strike price of the call. The call premium that exceeds the intrinsic value = its time value. If a call is not in the money, then the entire call premium is time value. Time value is maximized when the call is at the money and when there is considerable amount of time until expiration. However, time value declines most rapidly in the final month before expiration. Therefore, a good call writing strategy is to write calls about a month before expiration with a strike price as close to the current stock price as possible, since stocks generally decline in the last few weeks before options expiration and time value always rapidly declines in the weeks before expiration. This strategy can be repeated each month or periodically as long as the underlying is held.

If the stock goes into the money, then the call writer can close out his position by buying the call back, allowing him to retain ownership of the stock, which may be judicious if the stock is expected to climb even higher, but the buyback will reduce profits or incur losses. However, by buying the call back, the stock position is retained.

Covered Call Example for Google, Inc. (GOOG)
Acquired Position Date 5/14/2013
Cost Basis of Asset $885
Call Price $5
Call Strike Price $890
Call Premium $500
Last Trading Day for Calls 5/17/2013
Transaction Costs $0
Number of Shares 100
Breakeven Price $880
Final Stock Price Covered Call Profit Stock Profit
850 −$3,000 −$3,500
855 −$2,500 −$3,000
860 −$2,000 −$2,500
865 −$1,500 −$2,000
870 −$1,000 −$1,500
875 −$500 −$1,000
880 $0 −$500
885 $500 $0
890 $1,000 $500 Maximum Profit on Covered Call
895 $1,000 $1,000
900 $1,000 $1,500
905 $1,000 $2,000
910 $1,000 $2,500
913 $1,000 $2,800 High on final trading day was $913.49.

There are 2 major types of covered calls. An in-the-money covered call generally offers greater downside protection, while an out-of-the-money covered call offers greater profit potential. An out-of-the-money covered call depends more on increases in stock price to make a substantial profit for the call holder, but the call writer earns only small premiums that may not even cover transaction costs. However, an in-the-money covered call can earn a substantial profit for the call writer, especially even if the stock declines before expiration and the strike price is above the call writer's stock basis.

By continually writing short-term covered call options, the investor can continue to collect the call premiums plus any dividends on the underlying stock. A rolling action occurs when a written call is bought back and the call writer writes a new call with a different strike and/or expiration date. Rolling down is replacing a call with another call at a lower strike price to provide more downside protection for the call writer. The potential risk is that the call with the lower strike price may be exercised, thus forcing the call writer to sell his stock at the lower price.

When a call is certain to expire worthless, the call writer may want to roll forward his position by selling a later expiration date. However, if additional calls are written before the already written calls expire, then the call writer may be required to post margin if the writer does not have enough stock to cover all calls. It is always possible, though unlikely, that important news may cause a stock to spike in price, putting what seemed to be worthless calls in the money.

Generally, the call writer will want to continually roll forward his position, since the only commissions will be to write the new calls. There are no commissions on expiring calls. If the stock is called away, then the covered call writer must repurchase the underlying asset to continue the covered call strategy. But in certain cases, it may be preferable to let the stock be called away. Whether to roll forward or to let the stock be called away depends on the outlook for the stock and on the return of other possible investment opportunities.

Computing the Return on Investment

The covered call writer should consider both potential income and the downside protection in selecting a covered call to write. Stock dividends should also be considered in calculating the return. Using margin to buy the underlying stock can increase profits but will also increase potential losses. Additionally, the interest charged on the loan subtracts from that profit.

There are 3 basic scenarios of a covered call strategy that should be calculated to decide if it is desirable to enter into that position:

  1. the return if exercised
  2. the return if the stock price is unchanged at expiration
  3. the downside breakeven point after all transaction costs are included, thus ascertaining the percentage of downside protection that would be received by writing the call.

To compare the covered call strategy with other investment opportunities, the return should be annualized:

Annualized Investment Return = Investment Time Periods in Year × Net Profit
Net Investment

Covered Calls with Underlying Assets Other than Stocks

Calls can also be covered by convertible securities, either bonds or preferred stocks that are convertible into the underlying stock. Oftentimes, convertibles offer higher yields, increasing income for the holder of the asset. Warrants or LEAPS can also be used to cover calls that can lower the required investment.