Covered Call

Covered Call

A covered call is an options strategy where an investor sells (writes) call options while owning the underlying shares. The seller collects the option premium as income and must deliver the shares at the strike price if the option is exercised. This strategy is typically used when an investor expects the stock to remain neutral or rise only modestly over the option’s life.

Key takeaways

• Generates income from option premiums while holding the stock.
• Best when you expect limited upside in the near term.
• Caps upside beyond the call’s strike price but provides a small buffer against downside (the premium).
• Maximum loss is essentially the stock’s purchase price minus the premium received.

How it works

1. Own at least 100 shares of a stock (one option contract typically covers 100 shares).
2. Sell a call option with a chosen strike price and expiration.
3. If the stock stays below the strike, the option typically expires worthless and you keep the premium.
4. If the stock rises above the strike, you may be assigned and must sell your shares at the strike price (losing further upside, but retaining the premium).

This is often implemented as a buy-write: buying the stock and simultaneously writing a call against it.

Profit and loss

• Maximum profit = (premium received) + (strike price − purchase price), capped if the stock is called away. Example: buy at $90, sell a $100 strike call and collect $1.00 premium → max profit per share = $1 + ($100 − $90) = $11 (or $1,100 per contract).
• Maximum loss = purchase price − premium received (stock could fall to zero, leaving only the premium as offset).
• Break-even price = purchase price − premium received.

Advantages

• Generates steady income from premiums.
• Provides a limited hedge (the premium cushions small declines).
• Straightforward and relatively conservative compared with uncovered option selling.

Disadvantages

• Caps upside: you forfeit gains above the strike price.
• Requires owning—or being able to obtain—100 shares per contract if assigned.
• Offers limited protection against large downside moves.
• Not suitable if you are very bullish (you’d miss substantial gains).

When to use and when to avoid

Use covered calls when:
* You are neutral to mildly bullish on a stock and willing to sell at a specified price.
* You want to generate additional income from a long stock position.

Avoid covered calls when:
* You expect a large price surge (you’ll miss upside above the strike).
* The stock is highly volatile with large potential swings.

Alternatives

• Cash‑secured put — sells a put while holding enough cash to buy the stock at the strike; effectively a way to acquire stock at a discount while collecting premium.
• Collar — combine a covered call with a purchased protective put for downside protection (reduces net premium).
• Diagonal spreads — buy a longer-dated option and sell a nearer-term option at a different strike to take advantage of time decay and volatility changes.

Rolling covered calls

To adjust a covered call position:
* Roll up — buy back the existing call and sell a new call at a higher strike to recapture upside.
Roll down — replace the call with a lower strike to increase premium (reduces upside).
Roll out — extend expiration by replacing the call with one having a later expiration.
Combinations (roll up-and-out, roll down-and-out) change both strike and time.

Example

You buy 100 shares of TSJ at $25 and sell a three-month call with a $27 strike for $0.75 premium ($75 total).
* If TSJ ≤ $27 at expiration: option expires worthless, you keep the $75 and still own the shares.
* If TSJ > $27 at expiration: shares are called away at $27; you keep the $75 but forfeit any upside above $27.
Break-even on the position = $25 − $0.75 = $24.25.

Common questions

Q: Are covered calls profitable?
A: They can be, especially when used on stocks expected to trade flat or slightly up. Profitability depends on strike selection, premium collected, and subsequent stock movement.

Q: Are covered calls risky?
A: They are relatively conservative compared with naked option selling, but they do not protect against large drops in the stock and they cap upside.

Q: Can I use covered calls in an IRA?
A: Many custodians allow covered calls in IRAs. Rules and approval levels vary, so check with your broker.

Q: Is there a “covered put”?
A: Not commonly. The rough mirror is a cash‑secured put (selling a put with cash set aside to buy the stock). A “married put” (owning the stock and buying a put) provides downside protection.

Bottom line

A covered call is a practical, income-oriented strategy for investors who want to generate premium income while holding a stock but are willing to cap upside at the strike price. It’s most appropriate when you expect limited short-term gains and want a modest hedge against small declines.