What is a covered call?

The most common type of investing involves buying stock, holding on to it until it reaches a higher price, and then selling it for a profit. This can take a long time, months, even years. Another type of investing known as options trading offers an alternative to traditional buy-and-hold investing for those who want a quicker return on their money. Making a profit from options can take as little as a month or two.

Trading options involves buying and selling contracts for stock instead of the stock itself. The price of a contract, called the premium, represents the profit the seller of the option makes. The buyer makes a profit by trading the underlying stock.

What are covered calls?

One popular type of option, known as a call, gives the buyer the right, but not the obligation, to purchase the underlying stock at a fixed price before or when the contract expires. The seller is obligated to sell the stock at the fixed price if the buyer exercises their option to buy.

If you already own stock you can sell whats known as a covered call. A covered call means that if the buyer decides to exercise their option you are covered because you dont have to buy the stock on the open market, possibly at a high price. If you sell an option but dont own the stock, thats known as a naked call.

To help you better understand how covered calls work, you should know the following key terms:

An option or option contract conveys the right to buy or sell an underlying stock at a fixed price within a specified time period.
The premium is the price the buyer pays for the option contract. It also refers to the amount the seller receives. It is a per-share amount multiplied by 100. For example, $2 x 100 = $200 premium. A typical premium is about 2% of the stocks value.
The strike or strike price is the price specified in the contract at which the buyer can exercise their option and buy the underlying stock. It is also the price at which the seller is obligated to sell the stock to the buyer.
The break-even point of an option is the price or price range of the underlying stock at which there would be no profit and no loss.
A call option is at the money (ATM) when the market price of the underlying stock is the same as the strike price.
When the market price of the underlying stock is lower than the strike price it is out of the money (OOM).
A call is in the money (ITM) when the market price of the underlying stock is higher than the strike price.

When you sell a covered call, the premium you receive is yours to keep. If the market price of the underlying stock stays below or at the strike price until after expiration of the contract, and the buyer doesnt exercise their option, the premium represents your profit. And you still own the stock you used to back up your covered call.

If the market price of the underlying stock rises above the strike price before or at expiration, the buyer will exercise their option and you will have to sell your shares to them at the strike price.

The buyer may then sell the shares on the open market and keep the profit you would have earned if you had kept and sold the stock. However, you still have the premium plus any profit you made selling the shares at the strike price.

I call it a bird in the hand strategy says David Koch, Senior Advisor at Halbert Hargrove. You have premium income when you sell the call but give up potential capital gains. Its a bird in the hand versus a bird in the bush.

Selling covered calls works best if you believe your stock will remain close to its current price until after the expiration of the contract. The buyer, of course, believes the price will rise before or at expiration.

If you are the seller of a covered call, your profit is the premium you receive plus the difference between the price you paid for the stock and the strike price.

If you are the buyer of a covered call, profit is based on the eventual selling price of the stock minus the strike price (amount you paid), minus the premium you paid out.

Example of a covered call

Suppose you buy 100 shares of XYZ stock for $25 per share and that is the current market price. You dont expect this stock to go much higher anytime soon, so you decide to sell a covered call on your stock with a strike price of $30, a premium of $2 per share, and an expiration date two months from now.

A buyer, who thinks youre wrong and that the stock is going to go above $30 soon, purchases the contract and gives you $200 ($2 x 100 shares) in premium. Heres where you both stand:

You (seller) still own the stock and have $200 in premiums which you get to keep no matter what.
The buyer has a contract conveying the right (but not the obligation) to buy your stock for $30 a share anytime within the next two months. The buyer is also out the $200 he paid you in premiums.

Suppose, after 45 days, the stock you own is selling for $35 per share. The buyer decides to exercise his option and buy your shares for $30. He then sells them on the market and receives $500 ($5 x 100) profit from the sale. After subtracting the premium he paid of $200, his net profit is $300.

You no longer have your stock, but do have the $200 premium. Since you originally bought the shares for $25, you also receive $5 per share when you sell them to the buyer for $30. Your net profit is $500 ($5100) plus the $200 premium for a total of $700.

You missed out on the $10 per share profit you would have made if you kept the stock and sold it. Instead of $1,000 ($10100) in profit, you have $700. But you also would have made a profit if things went the other direction.

If the option would have expired worthless, you would have had a net profit of $200 and still owned the stock. You could then sell another covered call or wait until the stock reaches $30 and sell it then. In this second scenario, the buyer would have lost his $200 premium but no more.

Calls vs. puts

Recall that a call grants the buyer the right, but not the obligation, to buy the sellers shares for the strike price before or at expiration. Another type of option, called a put, grants the buyer the right, but not the obligation to sell the underlying stock to the seller of the option for the strike price before or at expiration.

The buyer of a call takes a long position, expecting the underlying stock to rise in value before or at expiration. The buyer of a put takes a short position, expecting the underlying stock to remain below the strike price. Conversely, the seller of a call takes a short position and the seller of a put takes a long position as illustrated in the table below.

The buyer of a call profits when the underlying stock rises above the strike price and the buyer of a put profits when the stock remains below the strike price.

The seller of a call takes a profit from the premium earned when the stock remains below the strike and when selling a put when the stock rises above the strike.

In all cases, the buyer of a call or put profits by selling the underlying stock and the option seller profits from the premium paid by the buyer plus any price difference in the stock if they sell it.

Pros and cons of selling covered calls

The benefits of selling covered calls include the ability to offset downside risk, generate income, and boost investment returns.

Selling a call option on stock positions you own is a very conservative investment strategy and a method to generate additional income, notes Robert R. Johnson, Professor of Finance, Heider College of Business. This is particularly useful for investors who are in retirement and are seeking additional income.

Benefits of covered calls

Offset downside risk
Generate a premium (income)
Boost investment returns

Drawbacks of covered calls

Unlimited risk if stock is sold
Lose money if the stock drops
Lost profit if buyer exercises option

Pros and cons of buying covered calls

Depending on your take on the underlying stock, there are benefits (and drawbacks) to buying covered calls as well.

In fact, in Johnsons opinion, buying a call option makes much more sense than selling one. When an investor buys an option the most they can lose is what they paid for the option. When someone sells an option they have a virtually unlimited liability if the price of the asset moves against them.