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Covered Call – Option Strategy

A covered call is a two-part strategy in which a stock is purchased or owned and a call is sold on a share-for-share basis. The term “buy write” describes the action of buying stock and selling calls at the same time. The term “overwrite” describes the action of selling calls against stock that was purchased previously. This is a very popular strategy because it generates income and reduces some risk of being long on the stock alone. The trade-off is that you must be willing to sell your shares at a set price, also called the short strike price. To implement this strategy, you purchase the underlying stock as you normally would, and simultaneously write/sell a call option on the same underlying.

Covered calls offer traders three potential benefits, income in neutral to bullish markets, a selling price above the current stock price in rising markets, and a small amount of downside protection. Traders should also be willing to own the underlying stock, willing to sell the stock at the effective price, and be satisfied with the estimated static and if-called returns. Losses occur in covered calls if the stock price declines below the breakeven point. There is also an opportunity risk if the stock price rises above the effective selling price of the covered call. The covered call’s PnL graph looks a lot like a short, naked put’s PnL chart. As long as the covered call is open, the covered call seller is obligated to sell the stock at the strike price. Although the premium provides some profit potential above the strike price, that profit potential is limited. Therefore, the covered call seller does not fully participate in a stock price rise above the strike. In the event of a substantial stock price rise, covered call sellers often feel that they missed a great opportunity.

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