A covered call is an options-trading strategy used by professional investors and traders. But individual investors and traders can also benefit from this relatively simple and conservative strategy. Investors can even use IRAs in their Individual Retirement Accounts (IRAs), where many trade strategies are often restricted.
Once the general concepts of a covered call are understood, investors and traders will have added a valuable asset to their arsenal of trading tools.
How a Covered Call Works
A covered call is generally used to generate additional income from a long stock position. The traditional steps of a covered call are buying a stock and simultaneously selling a call option against the stock position (or, even more typically, selling a call option on a stock that is already owned). Before moving ahead, however, let’s quickly take a look at what a call option is.
Call options are legal contracts that give the buyer of the option the right (not the obligation) to buy 100 shares of the underlying stock at the strike price any time before the option expires. The option’s strike price is the predetermined price for buying the stock before the option’s expiration date.
The seller of a call option, meanwhile, has the obligation to sell 100 shares of stock to the buyer of the call option if the buyer chooses to exercise this right. A covered call is said to be “covered” if the seller of the call option owns the underlying shares and is able to deliver the shares if the option is exercised without buying them in the open market. A call is not completely “covered” unless the trader owns 100 shares for every single call sold. For example, if an investor sells five calls, he needs to have at least 500 shares of the underlying stock.
When a call option is sold, premium is collected from the call buyer. This cash premium is paid for the right to buy the shares of stock at the strike price in the future. No matter what happens, it’s the seller’s premium to keep regardless of whether the call option is exercised.
A Covered Call’s Best-Case Scenario
The best-case scenario for a covered call is achieved when the stock moves just up to the strike price at expiration. In this scenario, the stock has moved up to its maximum potential without being called away and the sold call expires worthless. If the stock moves above the strike price at or possibly before expiration, the person who bought the call may exercise his or her right and make the investor sell him the stock at the strike price. This isn’t necessarily a bad thing because maximum profit was achieved but now the investor has relinquished the stock (and has possibly missed out on some upside).
If there is ever a time the investor needs to sell out of the stock before expiration, it is recommended that the option be bought to close as well. If not, the investor will be holding a “naked” call, the risk of which is theoretically unlimited if the stock rallies. Holding a “naked” option is not even allowed in most if not all IRAs.