Covered Call – A thorough examination

Content

• Introduction
• Definition – What is a Covered Call
• Mechanics of the strategy
• Benefits of the strategy
• Scenario and practical example
• Trader’s tips and considerations
• Conclusion

1. Introduction

In the world of options trading, the “Covered Call” strategy emerges as one of the most popular and most accessible strategies, recommended for those beginning option traders just starting their learning journey in options. This chapter seeks to explain what this option is all about, explain the mechanics, give the benefits and provide some important considerations together with examples of the covered call strategy. Due to its benefits, this is a great strategy and used by all levels of investors and option traders.

2. Definition & Objective – What is a Covered Call?

A covered call (abbreviation : “CC”) involves owning stock (or buying shares of a stock) and then selling a call option on that same stock, at a strike price higher than the actual share price of the market. 

The “covered” aspect means that you, the seller of the call option, own the underlying stock, thereby covering the obligation if the option is exercised. As a reminder : call option gives the buyer the right, but not the obligation, to purchase your stock at the strike price before the expiration date. So basically, being the seller of the covered call, you have granted someone the option to purchase your stock at a predetermined price and you receive a premium for that promise.

If you do not have 100 shares, then it would be called a Naked Call, which theoretical loss can be unlimited – make sure you know how to manage it!

So if you plan to sell a covered call, always ensure you have at least 100 shares of a stock before doing so (reminder : one option contract represents the right to buy or sell 100 shares of a stock).

The different objectives or the reasons why option traders like to apply this strategy is discussed below in the benefits paragraph.

3. Mechanics of the Strategy

4. Benefits of the Covered Call Strategy

The primary objective of the covered call strategy revolves around income generation and, to some extent, risk mitigation. Let’s delve deeper into the objective or rationale of selling a covered call. 

a. Generating income and improving the portfolio returns:

The premium received from selling the call option provides immediate income, which can be seen as a way to earn a passive return on your stock holdings. One of the primary motivations for using covered calls is that this strategy, can help to reduce the cost basis of your shares by bringing in premium income, that augments to the returns on an existing stock portfolio. 

In the context of covered calls, the cost basis of the shares refers to the original value of the stock when it was purchased, adjusted with the option premiums and dividends received. If you sell covered calls long enough, you might earn enough in premiums to offset the total cost of the underlying stock! Wouldn’t that be fantastic.

This premium received up front provides an immediate return on your investment, irrespective of the stock’s subsequent performance. Over time, regularly selling covered calls can lead to a significant boost in overall portfolio returns, especially in flat or moderately bullish markets.

b. Downside protection & mitigating risk (hedge): 

The premium received can also offer a slight buffer (a hedge) against minor declines in the stock’s price.

While the premium received from selling a covered call doesn’t provide full downside protection, it does offer a certain cushion against minor stock price declines. For instance, if you earn a $3 premium from selling a call option, your stock can decline by $3 per share before you start to see a net loss on your position. This buffer can be particularly valuable during periods of market volatility or uncertainty.

The covered call strategy balances profit potential with defined risk. Since you already own the stock, you’re protected from the infinite risk that ‘naked call sellers’ might face. Your risk is limited to potential lost profits if the stock surges past the strike price, but this is a risk you can control as we will see further on.

c. Strategic stock exit:

For investors looking for an organised way to offload a stock at a particular price, covered calls can serve this purpose. By selling a call option at a specific strike price, you can ensure that, if the stock price exceeds that level, the shares will be sold (assuming the option is exercised). If you plan to take profit at a specific level, this can be an efficient way to exit a position at a desired price while also earning the extra premium.

d. Compensating for stock stagnation:

In situations where a stock remains stagnant or experiences minimal growth over time, covered calls can introduce a way to generate higher returns. Instead of merely holding onto a non-performing or slow-performing asset, the investor can earn regular premiums, making the most out of a flat stock scenario.

e. The covered call strategy is a great tool to proactive portfolio management.

This strategy is also an integral part of the popular wheel strategy amongst option traders. By understanding and leveraging this technique, investors can turn potential stagnation into steady income, navigate volatile markets with added protection, and set clear objectives for stock exits. It embodies the principle that in the world of investing, there are always opportunities to be seized, even in the most unlikely circumstances.

For those new to options trading, the benefits of covered calls offer a relatively safe introduction into option trading. Since the call option is “covered” by the owned stock, the potential losses are not unlimited (as they could be with naked call selling). This provides a controlled environment for beginners to familiarise themselves with the mechanics of option selling.

5. Scenario and practical example

Let’s say, you own 100 shares of the stock Alphabet Inc (Ticker: GOOGL), currently trading at $136.50 for the long term. This means your position is worth $13,650.

You sell a 4 week call option with a strike price of $148 and receive a premium of $154 ($1.54 per share).

Selling this call, actually means that the buyer of the option will pay you immediately a total premium of $154, for you to be ready to sell the shares at $148 per share if the option will goes above the strike price of $148 in 31 days, and if that does not happen the contract expires worthless and you keep $154 in your pocket.

Scenario 1: The stock remains below $148. The option expires worthless, which is perfect if your objective was to earn the premium. Your profit is the $148 premium, which is the maximum profit of the call option. You can consider selling a new option to continue receiving premium. In this example, you can see in the options chain, that the call option has a delta of 0.24, indicating that there is approximately a 24% probability of the option expiring in the money, and getting assigned. This means an approximately 76% change of NOT getting assigned and the option expiring worthless (PoP of broker’s platform = 78%).

Scenario 2: Imagine the stock rises to $160 on the expiration date. You’re getting assigned (the option will get exercised). Whether this aligns with your desired outcome, depends on your initial trading strategy and initial objectives of putting on the covered call trade. You’ll have to sell the stock at $148 (the strike price). However, since you received a total premium of $154, your effective sell price per share is $149.54, which is still about $13 better than the current market price. You can’t profit of the full rise in value of the stock to $160, but then again, you can’t predict the market, but the premium received was 100% defined at opening the position.

You have received $14954 after all transactions (fees not considered) compared to the initial value of your position of $13,650.

6. Trader’s Tips and Considerations

Stock Selection: 

• When the market conditions, or the trend of a particular stock, is expected to have a modest rise, move sideways or is expected to go lower, covered calls can provide additional income on top of existing positions.
• It is important to select a stock that you are willing and prepared to sell, as the call option buyer has the right to purchase the stock at the strike price if they choose to exercise the option. So the probability always exists that you will get assigned to sell your shares if the options gets in the money.
• Covered calls are often best with stable strong stocks that have moderate growth year after year.

When implementing the covered call strategy, several factors come into play that can influence its success and its profitability. Among these, delta, duration, premium, and volatility are paramount. Let’s delve into each and elucidate their significance.

When selecting a suitable strike price and expiration date for a covered call option, the two primary considerations should be the current market and stock conditions and your personal risk tolerance.

• Strike price selection and option delta: 
  • Although strike selection fully depends on the individual objectives (“ready to sell the stock” or more tendency to keep the stock), for covered call sellers, selecting an option with a delta between 0.3 to 0.4 (often referred to as slightly out-of-the-money) is common, as it offers a balance between premium received and potential for stock appreciation.
  • Also keep the general share price trend and market trend in mind for the strike selection : while covered calls can be profitable, it can limit your upside potential in a strong bull market. Consider using CCs certainly more in bear markets and to adjust or make your strike selection carefully in a bull market.
  • There is a direct link between the strike price and Probability of Profit – Probability of Assignment (to exercise): Delta (see value in options chain) also provides a rough estimate of the probability of the option being exercised. For example, an option with a delta of 0.4 has roughly a 40% chance of being in-the-money at expiration.

• Expiration Selection or Option Duration – days till expiration (DTE): 
  • Duration refers to the time left, the number of days left until the option expires.
  • Shorter-term options tend to decay faster, which can be advantageous for the seller. As a reminder : options lose value over time, an effect called theta or time decay. Choosing shorter expirations also means you’ll be probably setting new strike prices more frequently.
  • Selling covered calls with shorter durations capitalises on this rapid time decay, allowing the seller to potentially earn more frequent premiums over the same time frame (premiums will be lower though). Shorter durations provide more frequent opportunities to reassess and be more flexible to adjust strategies based on stock price movements or changes in market outlook.
  • Selling a CC with a longer expiration date will typically result in a higher premium but also carries more risk.

• Premium and volatility:
  • The primary objective of selling covered calls is to earn a decent premium and lowering the cost basis of the acquired shares. Higher premiums can be enticing, but they often come with higher risks, such as a higher chance of the stock being called away.
  • As a reminder : Volatility measures the stock’s price fluctuations. Implied volatility (IV) represents the market’s forecast of stock price movement and influences option pricing. Stocks with higher IV will have higher (attractive and juicy) option prices, making it a more lucrative stock for covered call sellers. However, this comes with increased risk of large stock price movements.
  • A higher premium might be available on stocks experiencing high volatility around earnings or before major news events. While the potential income is higher, so is the risk of significant stock price movements.
  • The more advanced option traders can try to find an edge by comparing a stock’s historical volatility to its implied volatility and to give insights into market sentiment. If IV is significantly higher than historical volatility, it might indicate upcoming news or events that could impact the stock price.
  • Every option trader will have to learn to balance risk versus reward.

• Risks :
  • When selling covered calls, you are limiting your upside profit: if the stock price climbs significantly above the strike price and the option is exercised, you’ll be obligated to sell the shares at a rate below their current market value. This situation ultimately diminishes your profit potential compared to if you had opted not to write the covered call in the first place.
  • While you are selling more and more covered calls on the same stock, you are lowering its overall cost basis. If ths share price drops signifiicantly, it may be interesting to sell covered calls below the actual cost basis of that moment. Be aware that when selling covered calls below the cost basis of the shares, that you may risk to lock in a loss on the shares, if you would get assigned.
  • You can easily calculate your break-even price of your position : initial cost of the shares minus all premiums received minus all dividends received.
  • Always keep in mind that when you need to sell the stock you will have broker’s fees to pay for the transaction of the stock.

• Risk management :
  • As mentioned, you as the seller you are in full control of the risk at the opening of the position because you select the strike price and the expiration (!)
    • strike prices closer to the share price have an increased possibility of assignment, the benefit is that the premiums are juicier.
    • by selecting the strike price and expiration date, you have the flexibility to tailor the trade to be as aggressive or conservative as suits your preferences.
  • Selecting to sell a covered call at a moment of higher implied volatility (IVR) will also give higher premiums but evidently also large share price fluctuations. The implied volatility concept and the impact of it on option prices is one of the aspects that beginning traders must learn and experience.

• Monitor the price evolution and managing the position :
  • Always keep an eye on the underlying stock and any news that might impact its price, just to be sure you are on top of the outcome of your position
  • If you are trading CCs for cashflow (and lowering the cost basis), than :
    • ideally the share price stays the same, drops a bit, or at least stays below the strike price, then the option expires worthless;
    • if the share price falls heavily or we are getting closer to expiration, you can even consider closing the option early as its value will have decreased a lot and you will be close to reaching max profit on the option. I suggest you determine your own managing rule for this (for example > 80% of max profit)
    • When the share price goes above the strike price and you are getting scared that the shares will get called away, you can take a look at the extrinsic value of the option price. There is actually very little chance of getting your shares called away if your covered call still has some extrinsic value in the option price.
    • In case you have sold a covered call option and you’re no longer willing to sell the stock, you will have to close the position by buying back the option. Depending on the share price evolution, this will be for a net profit or net loss.
      • If you want to avoid of getting the shares called away, and the option is in the money and assignment is very likely, you can buy back the option by paying a premium higher than what you originally got for selling the covered call.
      • If the share price rises above the strike price, and the expiration is coming closer, you can always extend the duration of the option position by “rolling the position to a later expiration date and/or higher strike price“. This may be an unfamiliar concept to beginning option traders at first but it refers to the process of repurchasing a previously sold option and subsequently selling a new option with a later expiration date. If you do this, at a moment that the share price hasn’t spiked too much, it is even possible to roll out the position for an extra credit while extending the contract duration.

• Learning: the process of selling CCs is ideal for beginning option traders because it allows to learn :
  • Risk Management: It teaches you how to manage risk while participating in the market.
  • Income Generation: You can learn how to generate additional income from their stock holdings through premium collection.
  • Option Pricing: It provides a practical understanding of how option pricing works in real market conditions.
  • Portfolio Management: You can learn how to enhance the portfolio returns while owning stocks.
  • Market Analysis: It helps beginners to analyze market conditions and make informed decisions based on their market outlook and risk tolerance.

7. Conclusion

In summary, while the covered call strategy might seem straightforward at first glance, its success hinges on a nuanced understanding of the factors discussed above. By carefully considering delta, duration, premium, and volatility, you can make informed decisions, optimising their returns while managing potential risks.

The covered call strategy is a nuanced yet rewarding introduction to the world of options trading. By offering a balance of low risk, additional income generation, risk management and the possibility to learn and understand the basics of option selling, it’s a very popular tool for both novices, seasoned and professional traders. As always, a deep understanding and ongoing market research are crucial to maximising its potential.

This page aims to provide a thorough and comprehensive guide to the covered call strategy. However, like all trading strategies, it’s essential to be aware of the risks and to continually educate oneself to adapt to market changes. See the disclaimer.

I am sure this was useful, and in case you are new to option trading and want to learn more about options, I can suggest following content:

• Basic Option Trading Transactions
• Introduction to options trading – an attractive investment opportunity for all traders
• Cash Secured Puts – A deep dive

If you have any questions or comments, feel free to drop them in the comment section below or send me an email.

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