Covered Call

A covered call is an option strategy in which a call option is written against an equivalent amount of long stock. Example: Selling 2 XYZ May $60 calls for $2.00 while owning 200 shares or more of XYZ stock.

Each call option corresponds to 100 shares of the underlying stock.  You must own the stock BEFORE you sell the calls, hence the term "Covered" calls. By selling the call option, you are obligating yourself to sell the underlying stock at the strike price of the call, on or before the expiration date of the call option.  Normally the call option won't be exercised by the buyer of your call unless the underlying stock has risen to or above the combination of the strike price plus the call premium he paid.

In the above example:

1.You own 200 shares of XYZ stock.

2. You sell 2 calls for a $2.00/call premium, at a strike price of $60.00. (This = $200.00)

3. These calls will expire in May

(See the trade example below for more specific details)

When should an investor use the covered call strategy? Is timing that important, or doesn't it matter?  We'll answer these and other option trading questions on this page, by using specific trade examples and case studies.

Trading Options - Different Ways to Use Covered Calls

People often say that timing is everything, but is this always true when trading options?   Naturally, it depends upon what you're trying to achieve.  

For example, more conservative investors sell covered calls as an ongoing option strategy, augmenting their income with the money they receive for selling call options.  These investors tend to just hold onto their sold call positions until they either expire worthless or the underlying stock gets sold/assigned away from them at expiration.  They also tend to hold onto their underlying stock longer, particularly if it pays a good, reliable dividend.

Short term investors trade options much more aggressively, jumping in and out of covered call and covered put positions long before expiration rolls around. Volatility plays a big role in this latter, more aggressive option strategy, which is often used with volatile ETF's and index trades.  

Personally, I'm very skeptical about using this more aggressive, labor-intensive options strategy, since it usually is merely a very short term hedging technique that only serves to mitigate losses when the underlying stock suddenly tanks.

At the end of the day, it comes down to your reasons for owning the underlying stock you're selling the call option against.  If you buy a volatile ETF, hoping for short-term price appreciation, but then you sell a covered call against it, you're limiting both your upside and downside profit potential.  Contrast this with buying a dividend stock, for its income, and then increasing the short-term income by covered call writing.  The yield % you can make doing this can often outpace the % you'll make by using other, more aggressive options strategies.

Market Timing and Covered Calls

When is the best time to sell covered calls? Recent history shows that 2008-2009 has been a great time to use this options strategy. Why? Because, when the market declines, it usually takes most stocks with it, and, if you'd sold covered calls against the stocks you already owned, it would have helped you to cover some of the losses in price appreciation that your portfolio suffered.

Here's how: When you sell a call option, and the underlying stock declines, the call option usually declines too, although at a lesser rate. This rate of change is called its "Delta", which refers to how much an option will move in price when the underlying stock moves $1.00.

Call options have positive deltas, since calls move up/higher when the underlying stock moves up. Put options have negative deltas, since puts move in down when the underlying stock moves up.

Investors will also use delta as an indication of how likely it is that their option will end up "in the money". A call option with a high delta will have bigger price movements that correspond more closely than a call with a lower delta. Call options also have higher deltas the closer they are to the stock's current price.

So, if you're going to trade options in a conservative way, just to hedge your portfolio, and/or, to generate extra income, why should you care about delta, and being in the money or out of the money at expiration time?

When selling puts and calls, if your option is "in the money", it means that the stock is above the strike price of the call which you sold, and, conversely, below the strike price of the put that you sold. This is vital, because it helps to determine what will happen at expiration time. In addition, the further the option is in the money, the higher its price will be.

Covered Call Trade Example

Here's a covered call example that explains this further:

Let's assume that you just bought 100 shares of Bristol-Myers, (BMY), at $21.88, (today's closing price). If you wanted to sell a January, 2010 covered call option against your shares, you'd look at the Jan. 2010 option table and choose which call to sell.

The first row lists the strike price for each call. This is the price that you'll have to sell your 100 shares at, if your shares get assigned/sold. The calls at $21.00 and below are all "in the money", and their prices get higher the deeper you go in the money, or the lower the strike price is. Look at the fifth column, "Bid". This is what call buyers are currently offering for each call.

At first glance, you'd probably think that you may as well sell the most expensive call, the $2.50 strike price, (BMYAJ.X), which buyers are currently bidding $19.25 for. But, the problem is that you own BMY at $21.88. If you sell the $2.50 call, you'll have to sell it for $2.50 at expiration time, which is a $.13/share loss, ($21.88 - $2.50 = $19.38, $19.38 - $19.25 bid = -$.13).

The net resale profit for the various calls starts to get much more interesting at the $22.50 level, (symbol BMYAX.X). Although the bid prices are lower, the strike price is at or "Near-the-money", meaning it's close or just above the current stock price. 

Step 1. Buy 100 shares of Bristol-Myers, (BMY), at $21.88. (Cash Outlay: $2188.00)

Step 2. "Sell To Open" 1 Jan $22.50 call contract, (BMYAX.X), at the bid price of $1.21. (Cash back to you of $121.00). 

Step 3. You'd then collect $.62/share in dividends before expiration. (Cash back to you of $62.00)

At or near Jan. 15, 2010 expiration date, there will be 1 of 2 outcomes:

1. Static: If BMY stays relatively static, and doesn't rise to or past $23.71, (strike price plus bid price), you'll keep your 100 shares. Your total Static Yield: 8% ($1.21+ $.62 = $1.83 $1.83/$21.88 = 8%

2. Assigned: If BMY does rise to or past $23.71, your 100 shares will be assigned, (sold) at the $22.50 strike price, which will net you an additional $.62/share profit, or an assigned yield of 2%.

Bristol-Myers Call Options Table:

 
 
 
 
 
 
 
 
 
Options Expiring Fri, Jan 15, 2010
 
 
 
 
 
 
 
 
Call Strike Prices
Call Symbols
Last Price
Change
Bid
Ask
Volume
Open Interest
 
$2.50
BMYAJ.X
N/A
$0.00
$19.25
$19.45
0
15
 
$10.00
BMYAB.X
$11.90
$0.00
$11.75
$12.00
30
79
 
$15.00
BMYAC.X
$6.92
$0.03
$6.90
$7.00
27
843
 
$19.00
BMYAS.X
$3.35
$0.00
$3.30
$3.40
18
117
 
$20.00
BMYAD.X
$2.60
$0.22
$2.61
$2.64
1,272
37,491
 
$21.00
BMYAW.X
$2.01
$0.04
$1.97
$2.00
1
2,021
 
$22.50
BMYAX.X
$1.20
$0.19
$1.21
$1.24
193
8,077
 
$24.00
BMYAG.X
$0.71
$0.08
$0.68
$0.71
42
2,671
 
$25.00
BMYAE.X
$0.47
$0.08
$0.45
$0.47
30
23,976
 
$26.00
BMYAA.X
$0.34
$0.00
$0.28
$0.31
12
349
 
$30.00
BMYAF.X
$0.08
$0.00
$0.05
$0.07
10
9,370
 
$40.00
BMYAM.X
N/A
$0.00
N/A
$0.02
0
2,121
 
 
 
 
 
 
 
 
 
 

Trade Summary

Cost/Share: $21.88

Total Static Yield: 8% in 159 days, or 18% annualized. ($1.83/share ($1.21 covered call premium + $.62 dividend)

Breakeven: $20.05 (Breakeven and Total Static Yield are equivalent)

Potential Assigned Yield: 2% in 159 days, or 4.5% annualized. ($.62 difference between strike price and share price)

Total Potential Profit: 11% in 159 days , or 25% annualized

Notice how the call bid money is almost twice the dividend money? That's one of the great attractions of selling options - the yields are often much higher than a stock's dividend yield, depending upon the stock's volatility.

As you can see from these figures, you'll know your total potential profit before making a covered call trade. This is one more advantage of selling options. Instead of buying and holding, hoping for price appreciation, you'll know exactly what your upside and downside are, so you can compare different trades against each other. (This is the reason I listed the annualized yields here - Since option expiration months vary, the best way to compare 2 trades is to annualize their yields.)

Options Strategies & Trading Tips

1. When employing options strategies, such as selling a covered call or selling a put option, try to make sure the underlying stock your selling against is worth owning. There are many investing metrics listed in my High Dividend Stocks hub page.

2. If you're very bullish on a stock, or the market, you may not want to sell covered calls at that point in time, unless you're OK with the possibility that the stock may be assigned/sold away from you.

3. Always make your option trades "Good For the Day Only", in case of a big overnight price change, or some other unforeseen problem.)

4. If the market or your stock has rallied and you think its current price is too expensive, you can still profit by selling puts against it. I discuss this another hub page, which has a link below.

5. Unless your afraid of a big price decline in the underlying stock, avoid selling covered calls at strike prices more than 3% below your stock's cost basis, as this could potentially hurt your final profit.

6. Always make sure you own or buy the underlying stock first, BEFORE selling calls against it. I do not recommend selling naked calls, ever. Your potential loss is unlimited if you do, since you'd be obligated to sell a stock at a given price, and, if it rises very high, you'll have nothing to "cover" your trade. (Hence the name - "covered" calls.)

Covered Calls Vs. Other Options Trading Strategies

Using the covered call approach to options investing is just one of many options trading strategies you can use to make money. I personally have found it to be one of the most consistently profitable ways to trade options, particularly in volatile markets such as we've seen in 2008 and 2009.

I'll discuss some other strategies for trading options in my future hub pages. Stay tuned for details about straddles, spreads, collars, condors and more.

Comments 2 comments

yamanote profile image

yamanote 7 years ago from UK/Spain

I think this article would be great if you could add a brief explanation of just what a covered call is at the start of the article


MRdivman profile image

MRdivman 7 years ago Author

Good idea. Thanks!

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