Covered Calls: What Are They And How Do You Trade Them?

Covered Call Writing

Covered Call Writing

Covered call writing is a valid strategy when the market is either bullish or trading in a narrow range.

Selling out-of-the-money call options on an existing stock position is an example of a covered call option play. These short calls are hedged with a position in the underlying stock, which absorbs the risk of an increase in value. In other words, the call writer can only lose money on the stock position, not the short calls.

Strategic Covered Calls

Any stockholder can write one covered call option contract for every 100 shares of stock they own. This is a method for earning extra money by collecting option premiums on already established positions. Covered call writing carries the risk that the underlying shares will decline in value below the option premium paid before the option expires. If the option price closes above the covered call strike price, the stock will be called and the investor will avoid taking on the call option’s upside risk.

The covered call buyer receives all of the stock’s potential appreciation, while the writer of the call is limited to collecting only the premium received for his or her shares. Before the short call becomes in the money, the covered call writer is eligible to collect any capital gains.

The premium collected by the writer remains their property regardless of whether or not the covered call options expire in the money. Before the short-covered call options expire, the option writer can buy them and then write a new call on the stock. The option seller stands to gain from the daily theta decay on call options if the underlying stock price doesn’t fall by more than the call option’s strike price.

As the covered call option’s premium declines as it moves further out of the money in response to a decline in the stock price, it provides some protection against the underlying stock’s decline in value. In most cases, a covered call writer will try to sell a call option with a strike price high enough that the underlying stock’s price won’t reach that level before the option expires.

In the covered call option strategy, the primary objective is to retain ownership of the underlying stock position and to pocket the entire premium received for selling the underlying option before it expires worthless. This allows for multiple calls to be written on the same stock, each time generating a premium large enough to cover the cost of the stock and produce revenue.

Additionally, covered call options can be used to sell a stock holding at a predetermined price. When the stock price reaches the covered call writer’s target, the writer will sell the shares at the option’s strike price and let the stock be called away in exchange for the premium collected.

Covered calls are riskiest when written on stocks with low fundamental and technical volatility. The risk associated with holding equities with lower volatility is also reduced. Covered calls pose most of their danger in the underlying stock. Option chains should be used that have ample liquidity and low bid/ask spreads. When a covered call option’s value has dropped significantly and the risk-to-reward ratio no longer favors further decline in the premium, it may be prudent to purchase back the option. Typically, the point of a covered call option trade is to earn money off of stock that the investor already intends to hold.

Does the risk of loss exist in a covered call?

There is a risk of loss in a covered call option trade if the stock price drops below the short call option’s value before expiration. As a result, the play would end up costing you money. However, more revenue can be generated by selling a call option. Given that the stock is being used to offset the short-call option’s risk, the stock itself is the risky part of the options trade. There is a chance of making a net profit on the call option premium even if the covered call goes deep in the money and some capital gains on the stock are lost and the shares are also called away.

When selling covered calls, how far out can I go?

More time value is received when call options are sold further out, but the value of the option declines more gradually since it has more time to go in the money.

It is best to sell covered calls between 30 and 45 days before expiration in order to maximize premium and minimize time decay. In order to make the option play worthwhile, you need to sell a contract with a high enough premium. Covered call selling is done at a discount of about 2% of the stock price.

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