What Is a Covered Call Option?

If you own a covered call option, you own both a call option and the amount of the underlying security. A covered call option is generally considered the safest and most conservative approach to owning call options because the risk is very limited and the profit potential is modest.

The Mechanics of a Covered Call

Covered call options involve writing, or selling, call options against a stock position that you have established prior to selling the calls. Once you already own the shares of the stock, if you then sell call options against your position, you have written covered calls. When you write a call option, you are giving the buyer the right, but not the obligation, to purchase 100 shares of stock from you for a set period of time and at a set price.

If you do not own the shares when the option is exercised, you must then purchase the shares in the open market at the then prevailing price. When you write a call option without also owning the underlying stock, it is called a naked call option. With a covered call, since you already owned the stock, if the buyer of the option exercises the option, you must simply delivery the shares of the stock that you already own. The option is referred to as being covered because your market exposure is “covered” by the stock position that you have. You are not exposed to movements in the stock that could create risk because you can deliver the required shares out of your held portfolio.

Why Trade Covered Calls

The risk involved in writing covered calls is far less than it is when trading naked call options. As you can see, the risk on the option is limited by the shares of the stock, as opposed to the naked option where the risk is unlimited. With a naked call option, if the stock were to appreciate infinitely, you would have to buy the shares to satisfy the contract at the infinitely high price. The risk, therefore, has no cap.

The downside of a covered call, however, is that it requires significantly more capital, which in turn decreases the percentage return possible. For example, if you write a call option for $3 on a stock trading at $50, you will receive $300, for the call but need to spend $5000 to purchase the stock. If the option were naked, you would simply receive the $300 and hope that the stock’s price fell – the result would be a $300 profit.

With a covered call, the $300 essentially lowers your cost basis, but if the stock falls, the option will not be exercised, but you will lose on your stock position – the maximum gain is for the option to expire when the stock is at the strike price. The potential profit is far lower with the covered call, but the risk is as well. In most cases, you should only write covered calls when you are interested in owning the underlying stock independently from the option trade.

blog comments powered by Disqus