A covered call is an options trading strategy where an investor holds a long position in an asset and simultaneously sells call options on that exact same asset to generate income from the option premiums.
Mechanics of a covered call
The core of this strategy relies on owning the underlying financial instrument before writing the options contract. When investors sell a call option, they give the buyer the right to purchase their shares at a predetermined strike price before a specific expiration date. In exchange for granting this right, the seller receives an upfront cash payment known as a premium. Contract sizes vary by international exchange, though a single options contract frequently represents 100 shares of the underlying equity.
The primary objective for executing a covered call is to generate yield on a portfolio that the investor intends to hold long-term. If the market price of the asset remains below the agreed strike price until the expiration date, the buyer will not exercise the option. The contract expires worthless, and the seller retains full ownership of their original shares alongside the premium they collected at the start of the trade.
The risk associated with a covered call involves capping the upside potential of the investment. If the asset price rises above the strike price, the buyer will exercise the option to purchase the shares at a discount to the current market rate. The seller is obligated to hand over their shares at the strike price, missing out on any further capital appreciation. The position is considered covered because the seller already owns the necessary shares to fulfill the contract, protecting them from the risk of buying the asset at elevated market prices to meet their delivery obligation.
Example
Suppose an Elephant owns 100 shares of Global Peanut Corporation, which is currently trading at 50 per share on the open market. Our Elephant decides to write a covered call with a strike price of 55 that expires in one month, receiving a premium of 2 per share. This transaction immediately adds 200 in cash to their brokerage account.
If the stock price of Global Peanut Corporation stays below 55 through the expiration date, the option buyer has no reason to exercise the contract. The contract expires, and the Elephant keeps both the 100 shares and the 200 premium. They are then free to sell another covered call for the following month.
If Global Peanut Corporation experiences a surge in demand and the stock price jumps to 65, the option buyer will exercise the call. The Elephant must sell their 100 shares to the buyer at the agreed 55 strike price. The Elephant secures a profit from the 5 per share stock appreciation and the 2 per share premium, but they do not participate in the stock’s continued climb from 55 to 65.