Covered calls are a sophisticated yet accessible financial strategy used by individuals and businesses worldwide. They revolve around options trading, providing a means to generate income from existing stock holdings, and are frequently used for hedging risks. This article seeks to elucidate the concept of covered calls, unraveling its complexities for anyone interested in learning about the strategy.
At the very heart of a covered call is a blend of two components: a long position in an asset (usually a stock) and the selling (writing) of call options on that same asset. In simpler terms, if you own a stock, you can write a contract allowing someone else to buy that stock at a specific price within a specific timeframe. This contract is the ‘call option’. Because you already own the stock in question (the ‘covered’ part), you are protected should the buyer choose to exercise their option.
Now, why would someone sell a call option on a stock they own? The answer lies in the premium. When you write a call option, the buyer pays you a premium upfront. This premium is yours to keep, regardless of whether the option is exercised or not. Hence, selling covered calls can generate additional income from your stock holdings, making it an appealing strategy, especially in flat or mildly bullish markets.
To illustrate this, let’s assume you own 100 shares of Company XYZ, currently trading at $50. Believing the stock will remain around the same price for the next month, you decide to write a covered call. You sell one call option (equivalent to 100 shares) with a strike price of $55, expiring in one month, and receive a premium of $200.
If the stock remains under $55 by the expiration date, the option will not be exercised, and you’ll retain your shares while pocketing the $200 premium. However, if the stock price increases above $55, the buyer may exercise their option, buying your shares for $55 each. You would still keep the premium, plus make a profit from selling your shares at a higher price.
Cons of Covered Calls
Covered calls, like any investment strategy, carry certain risks and drawbacks. While they can generate income and offer some downside protection, it’s essential to understand these downsides to ensure the strategy aligns with your overall investment goals and risk tolerance.
- Limited Upside Potential: Limited upside potential is one of the main downsides of using a covered call strategy. This is a result of the obligation you take on when you write a covered call.
When you sell (or write) a covered call, you’re giving the buyer the right to purchase your stock at a set price, known as the strike price, within a specific period. In return for this right, you receive a premium.
The catch is that if the price of the underlying stock rises significantly and goes above the strike price, you won’t be able to participate in those additional gains. Instead, you’ll be obliged to sell your shares at the lower strike price if the buyer chooses to exercise the option.
For example, suppose you own shares in a company that are currently trading at $50, and you decide to write a covered call with a strike price of $55. If the stock price rises to $70 before the expiration date, the buyer of the call option can choose to exercise the option and buy your shares for $55 each, even though they are now worth $70 on the market. While you keep the premium you collected and the profit up to the strike price, you miss out on the additional $15 per share gain.
In a bull market or when a stock’s price rises rapidly, this can significantly limit your profit potential. You’ll earn the premium and potentially some profit on the stock (up to the strike price), but you’ll forgo any further gains beyond that. For investors who believe their stocks have considerable upside potential, this can make covered calls a less appealing strategy.
On the flip side, the limited upside is the trade-off for generating income (the premium) and providing some downside protection. Covered calls are typically used when you anticipate the underlying stock will have modest price movement and you want to generate income from the premium in the meantime. However, it’s crucial to understand that this comes at the cost of missing out on significant potential profits if the stock price does end up rising substantially.
- Downside Risk: While writing covered calls can provide some downside protection through the premium income received, this strategy does not completely shield the investor from significant losses if the underlying stock’s price falls dramatically. This exposure to downside risk is one of the key drawbacks of a covered call strategy.
When you write a covered call, you receive a premium, which can help offset a decrease in the stock’s price. However, this protection is limited to the amount of the premium. If the stock’s price falls far below the strike price, the losses on the stock could be more than the premium income, leading to a net loss.
For example, suppose you own a stock currently trading at $100 per share, and you write a covered call option and receive a premium of $3 per share. If the stock’s price falls to $90 per share, your loss on the stock is $10 per share. Although you received a premium of $3 per share, you would still have a net loss of $7 per share. If the stock’s price falls even further, your losses could be substantial.
In contrast, if you simply owned the stock without writing a covered call, you could choose to hold onto the stock and wait for its price to rebound, assuming you believe in the long-term prospects of the company. However, with a covered call, if the stock’s price falls significantly, you are still obligated to sell your shares at the strike price if the option is exercised, potentially locking in your loss.
It’s also worth noting that while the premium provides some cushion against losses, it can create a false sense of security. The premium represents a fixed amount of income, whereas the potential for loss is essentially unlimited until the stock price reaches zero. Consequently, in periods of high volatility or market downturns, the downside risk of owning the stock can far outweigh the benefits of the premium received from the covered call.
- Stock Ownership Obligation: The requirement to own the underlying stock when writing a covered call, often referred to as stock ownership obligation, can pose certain challenges and is considered a downside for several reasons.
Capital Allocation: To write a covered call, you need to own the underlying stock. Depending on the stock’s price, this could require a significant investment. This capital is then tied up in the stock and can’t be used for other potential investment opportunities. The money invested in the stock could be earning a return elsewhere, which is a cost known as opportunity cost.
Upfront Cost: If you’re interested in using covered calls for income generation but don’t already own the stock, you’ll need to purchase the stock first. This could represent a substantial upfront cost. This is especially true if you’re dealing with high-priced stocks or if you’re planning to write contracts for a large number of shares.
Risk Exposure: Owning a stock means you’re exposed to all the risks associated with that stock, including company-specific risks and market risks. If the company performs poorly or if the overall market falls, you could face significant losses. While the premium from writing the call provides some downside protection, it may not be enough to fully offset large declines in the stock’s price.
Reduced Flexibility: Once you’ve written a covered call, your ability to sell the underlying stock is limited until the option expires or is exercised. If the stock’s price rises sharply, you can’t sell the stock to realize your gains without first buying back the call option, which could be costly. Similarly, if the stock’s price falls, you can’t sell the stock to cut your losses without dealing with the call option.
Potential for Losing the Stock: If the stock’s price goes above the strike price and the option is exercised, you’ll be obliged to sell your stock, potentially missing out on further gains. If you were planning to hold the stock long-term for its growth potential or for its dividends, being forced to sell the stock could disrupt your investment plan.
- Possibility of Early Assignment: The possibility of early assignment is one of the potential downsides of writing covered calls. This is an event where the buyer of the call option chooses to exercise their option before the expiration date. While early assignment is generally less likely due to the loss of time value, it can still occur under certain circumstances, particularly with American-style options that can be exercised any time before expiration.
Here’s why early assignment can be a downside:
Disruption of Strategy: If early assignment occurs, it can disrupt your investment strategy. You may have planned to hold the underlying shares for a longer period for capital appreciation or dividend income. Early assignment forces you to sell your shares sooner than you might have intended, which could potentially lead to missed opportunities for additional gains or lost dividend income.
Potential for Unexpected Capital Gains: Early assignment could also lead to unexpected tax implications. If the option is exercised and you’re forced to sell your shares, you may realize capital gains, which could increase your tax liability for the year. If the shares have appreciated significantly since you bought them, the tax implications could be substantial.
Reinvestment Considerations: After an early assignment, you’ll need to decide what to do with the proceeds from selling your shares. If you want to continue writing covered calls, you’ll need to purchase new shares, which could involve transaction costs. Alternatively, if you want to invest the proceeds in a different security, you’ll need to spend time researching and selecting a new investment.
Market Volatility: Early assignment is more likely when the market is volatile, and the stock’s price has risen sharply above the strike price. This could lead to you missing out on significant gains if the stock’s price continues to rise after you’re required to sell your shares.
Dividend Risk: If the underlying stock pays a dividend that’s larger than the remaining time value of the option, the call option holder might exercise the option early to capture the dividend, which could lead to you missing out on the dividend payment.
- Complexity and Transaction Costs: The complexity of options trading and the associated transaction costs are certainly noteworthy downsides to employing a covered call strategy. Let’s delve into both aspects:
Complexity: Unlike buying and selling stocks, which most investors understand fairly well, options trading, including covered calls, involves a higher level of complexity. Options are derivative instruments, meaning their price is derived from an underlying asset, such as a stock. Understanding how options are priced requires knowledge of several variables, including the underlying stock price, strike price, time to expiration, volatility, and interest rates.
Additionally, implementing a covered call strategy involves several decisions: what strike price to choose, when to sell the call, how long until the option expires, and what to do if the stock price moves significantly. These choices each carry their own risks and benefits, and they require an ongoing understanding of the market and the specific stock involved.
Furthermore, you need to track your portfolio closely and be ready to react if the option buyer decides to exercise their right. This level of active management may be more than some investors are comfortable with or have time for.
Transaction Costs: Every time you write a covered call, you may incur transaction costs. These costs can include commissions, which some brokers still charge, and the bid-ask spread, which is the difference between the price at which you can buy an option (the ask price) and the price at which you can sell it (the bid price).
If you’re writing covered calls frequently, these costs can accumulate and eat into your profits. If the premium you receive from writing the option is small, transaction costs might even result in a net loss from the trade.
Additionally, if the option is exercised, there may be additional transaction costs associated with selling the underlying stock. And if you decide to buy back the option before it’s exercised, you’ll incur additional costs as well.
- Active Management Requirement: The requirement for active management is indeed a significant downside of using a covered call strategy. Unlike a buy-and-hold strategy, which involves minimal monitoring and decision-making once the initial investment is made, a covered call strategy requires continuous oversight and decision-making. Here’s why:
Market Monitoring: Covered call writers must regularly monitor the market and the specific stock on which they’ve written the call. They need to keep an eye on the stock’s price relative to the strike price of the call, the remaining time until the option’s expiration, and other factors that could affect the option’s price or the likelihood of it being exercised.
Decision Making: Writing a covered call involves making several decisions, such as choosing the strike price and expiration date for the call option, based on your outlook for the stock and the market. These decisions aren’t a one-time event; each time you write a new covered call, you’ll need to reevaluate these factors.
Adjustment of Positions: Depending on how the stock’s price moves, you may need to adjust your position. For example, if the stock’s price falls significantly, you might decide to buy back the call option and sell the stock to limit your losses. Alternatively, if the stock’s price rises well above the strike price, you might decide to buy back the call option to avoid having your stock called away. These adjustments require time and attention, as well as additional transaction costs.
Risk Management: Active risk management is crucial when writing covered calls. You must be prepared to react if the stock’s price changes dramatically, or if there are other significant changes in the market or the company. This can include setting stop-loss orders to limit potential losses, or using other risk management techniques.
Time Commitment: All of this monitoring, decision-making, and adjusting of positions takes time. If you’re not willing or able to dedicate this time to managing your investments, a covered call strategy could be more stressful and less successful than a simpler strategy.
Pros of Covered Calls
Despite these risks, why would investors use this strategy? There are several compelling reasons:
- Income Generation: Income generation is one of the key elements that make covered calls an intriguing strategy for many investors. The ability to earn a steady stream of income, in addition to any dividends from owning the underlying stock, is appealing and can enhance overall returns from an investment portfolio.
Here’s how income generation works with covered calls:
When you write a covered call, the buyer of the option pays you a premium upfront. This premium is immediate income that you receive just for agreeing to sell your shares at a certain price within a specified timeframe. It’s a bit like receiving rent from a tenant; the tenant pays you for the right to potentially buy your property, but until they do, you still own the property.
This premium income is yours to keep, no matter how the option contract is eventually resolved. Whether the buyer exercises the option or it expires worthless, you retain the premium, providing an immediate and guaranteed return on your investment.
For example, let’s say you own 100 shares of a company that’s currently trading at $50 per share. You decide to sell a call option with a strike price of $55 and an expiration date one month in the future, and you receive a premium of $2 per share, or $200 total. You earn this $200 immediately, regardless of whether the stock’s price goes up, stays the same, or goes down. Even if the stock’s price never reaches $55 and the option expires worthless, you’ve still made a $200 profit from selling the option.
This ability to generate income consistently can be particularly appealing during periods of low interest rates or market volatility. While the stock market might be fluctuating wildly, and interest rates on safer investments like bonds or savings accounts are low, the income from covered call premiums can provide a reliable, steady return. This can help smooth out returns and potentially improve the overall risk-reward profile of an investment portfolio.
It’s important to note, however, that while selling covered calls can generate income, it also caps potential gains and doesn’t fully protect against losses if the stock’s price drops significantly. As with any investing strategy, it’s crucial to understand the risks and benefits fully before deciding whether it’s the right fit for your financial goals and risk tolerance.
- Downside Protection: Downside protection is another important aspect that makes covered calls appealing to investors. While the covered call strategy can’t completely shield an investor from significant market downturns, it does provide a degree of downside protection that owning stock alone doesn’t offer. This concept centers on the premium collected from writing the call option, and it works as follows.
When you write a covered call, you receive an option premium immediately. This premium serves as a buffer against potential losses should the price of the underlying stock decline. Essentially, the premium amount offsets a corresponding decrease in the stock’s value.
Consider an example where you own 100 shares of a stock currently trading at $50 per share. You decide to write a covered call and collect a premium of $2 per share, or $200 for the contract. If the stock’s price drops, the $200 premium will offset the first $2 per share (or $200 total) decrease in the stock’s value.
So, if the stock’s price drops to $48, while you’ve technically lost $200 on the stock value, you’ve already received a $200 premium from selling the call option. Therefore, your net loss is zero. If the stock’s price drops more than $2 per share, you start to see a net loss, but it’s still less than what you would have experienced had you merely owned the stock without writing the covered call.
This downside protection aspect becomes especially attractive in uncertain or bearish market conditions. If you believe the stock’s price might decline in the short term, writing a covered call allows you to generate income (the premium) while providing a cushion against potential losses.
However, it’s crucial to remember that the downside protection is limited to the amount of the premium received and doesn’t protect against substantial declines in the stock’s price. If the stock’s price falls significantly, the losses could exceed the premium income. Therefore, while the covered call strategy can improve the risk-return profile of a stock investment, it does not eliminate risk altogether. Understanding these nuances is key to implementing covered calls effectively in your portfolio.
- Market Views: Covered calls can be particularly appealing if an investor’s market view suggests that the prices of their held stocks are likely to remain relatively stable, or appreciate moderately over the term of the option contract. This strategy allows investors to capitalize on their market views in a way that simply holding or selling stocks outright may not.
Here’s how market views come into play:
Flat Market View: In a flat market, where you anticipate the price of your stock to remain relatively constant, writing covered calls can be a way to generate additional income. Even though the stock price is not appreciating, the premium collected from selling the call option provides a return. If the stock price stays below the strike price of the option, the option expires worthless, allowing you to keep both the stock and the premium.
Mildly Bullish Market View: If you believe that the stock’s price will increase, but only modestly, a covered call can also be advantageous. You can write a call option with a strike price above the current stock price. If the price increases as anticipated but stays below the strike price, you’ll benefit from both the appreciation of the stock and the premium from the written call.
Limited Downside Risk: Even with a mildly bearish market view, writing covered calls can still be beneficial. If you anticipate a small decrease in the stock price, the premium received from writing the option can offset this loss to some extent, providing downside protection.
However, it’s important to note that covered calls aren’t optimal for all market views. If you believe the stock price will skyrocket, writing a covered call might limit your potential profit, as you’re obliged to sell the stock at the strike price if the option is exercised. Similarly, if a significant drop in the stock price is expected, the premium from a covered call may not provide sufficient downside protection.
Covered calls are a versatile strategy, adaptable to various market conditions and investor goals. They provide a method to boost income and manage risk, adding another layer of sophistication to an investment portfolio.
However, like all investment strategies, covered calls require a comprehensive understanding before implementation. They involve particular risks and complexities, and might not be suitable for all investors. As with any investment decision, it’s crucial to consider your financial goals, risk tolerance, and market understanding before diving into the world of options trading.
Building upon the foundational understanding of covered calls, it’s crucial to recognize the factors influencing their success. Three key variables affect the profitability of this strategy: the underlying asset price, the strike price, and the expiration date.
Underlying Asset Price: The underlying asset price, typically the price of a stock, is a fundamental factor affecting covered call strategies. It influences the profitability of the strategy, the likelihood of the option being exercised, and the amount of premium that can be collected. Here’s how the price of the underlying asset interacts with a covered call:
At The Time Of Writing The Call: When you write a covered call, the current price of the underlying stock impacts the premium you can collect. Generally, the higher the stock price relative to the strike price, the more premium you’ll receive. This is because there’s a higher probability of the stock being above the strike price at expiration, making the option more valuable.
During The Option Contract Period: Changes in the stock’s price during the contract period can affect the outcome of the covered call strategy. If the stock’s price stays below the strike price until the expiration date, the call option will likely expire worthless. You keep the premium and the stock, providing income and allowing you to write another covered call if you wish. If the stock’s price rises above the strike price, the call option could be exercised. You’ll have to sell your shares at the strike price, but you still keep the premium. Although this caps your potential gain from the stock’s price increase, the combination of the premium and the gain from selling the stock can still provide a decent return. If the stock’s price falls, the premium you received helps offset the loss. However, a significant drop could lead to overall losses, as the premium can only offset a limited amount of the decrease.
At The Expiration Of The Option: The price of the stock at the option’s expiration significantly impacts the final outcome. If the stock price is below the strike price, the option expires worthless, and you keep the premium and the stock. If it’s above the strike price, the option is likely to be exercised, and while you keep the premium, you have to sell the stock at the strike price.
Strike Price: The strike price – the predetermined price at which the call option buyer can buy the stock – is a crucial aspect of the covered call strategy and can significantly affect its outcomes.
Premium Received: The choice of strike price affects the premium you receive for selling the call option. If the strike price is close to the current stock price (at-the-money), you’ll generally receive a higher premium because there’s a greater chance that the option will be exercised. If the strike price is much higher than the current stock price (out-of-the-money), the premium will be lower due to the smaller likelihood of the option being exercised.
Profit Potential: The strike price also sets the maximum profit you can gain from the strategy. If the stock’s price rises above the strike price, your profit is capped at the difference between the stock price at the time you sold the call and the strike price, plus the premium received. This is because if the option is exercised, you are obliged to sell the stock at the strike price, not the higher current market price.
Downside Protection: The premium received from selling a covered call provides some downside protection, and a higher strike price (and therefore a higher premium) can increase this protection. However, if the strike price is too high and the premium too low, the downside protection may be insufficient.
Ownership of Underlying Assets: If the stock price is above the strike price at the expiration date, the option is likely to be exercised, and you’ll have to sell your stock at the strike price. This may not be desirable if you wish to maintain ownership of the stock for long-term gains or dividend income. Choosing a strike price well above the current stock price can decrease the likelihood of the option being exercised.
Expiration Date: The expiration date of a call option is another key component that influences a covered call strategy. It refers to the date at which the option contract expires and can no longer be exercised. Here’s how the expiration date affects covered calls:
Premium Received: The expiration date has a direct impact on the amount of the premium collected when writing the call option. Options with longer expiration dates (also known as longer-dated or LEAP options) usually have higher premiums because they give the buyer the right to purchase the stock at the strike price for a longer period, increasing the chance that the stock price will move in the buyer’s favor. On the other hand, options with shorter expiration dates (short-dated or weekly options) have lower premiums because the likelihood of significant stock price movement within a short period is lesser.
Turnover Rate: The frequency of writing covered calls can be influenced by the choice of expiration date. Shorter-dated options allow for more frequent turnover, potentially providing more opportunities to collect premiums. However, this also requires more active management and monitoring of the portfolio.
Price Appreciation Potential and Risk Exposure: The expiration date also affects the duration of exposure to changes in the underlying stock’s price. A longer expiration date means your potential for stock price appreciation (up to the strike price) and risk exposure (if the stock price falls) both extend over a longer time frame. Conversely, a shorter expiration period limits both your potential for stock price appreciation and risk exposure.
Exercise Probability: Options with shorter expiration dates are less likely to be exercised, as there’s less time for the stock price to move above the strike price. This could be advantageous if you wish to keep ownership of the underlying stock. However, options with longer expiration dates, while they attract higher premiums, have a higher likelihood of being exercised.
The covered call strategy demands constant monitoring and adjustment according to market dynamics. It’s not a ‘set-and-forget’ method, as it might require rolling out options (buying back the current option and selling another with a later expiration date) to manage positions effectively.
Using covered calls involves a thorough understanding of options trading, and it’s wise to do so under the guidance of a financial advisor or broker initially. Many online brokerages offer platforms that support options trading and provide resources to learn more about the strategies.
Remember, investing inherently involves risk, and utilizing options is no different. It’s essential to assess your risk tolerance, investment goals, and level of understanding before implementing a covered call strategy. With careful planning, thorough research, and constant vigilance, investors can employ covered calls to their advantage, optimizing their portfolios in varying market scenarios.
