Covered Call Strategy

Why Use the Covered Call?

Although the covered call is technically considered an options trading strategy, it isn't a strategy that is used to make profits solely from options. It's designed primarily to return a profit when stock that you own goes through a period of remaining neutral i.e. it neither goes up nor down in price.

Typically you would use it if your outlook on stock you own is neutral, but you don’t particularly want to sell it and you would prefer to try and make some profits out of the price not moving. You can also use it to reduce any losses you may incur if the stock falls in price, although it's not particularly effective if it falls by much. The protective put is a better choice if you are looking for protection against any sizable fall.

Establishing the Covered Call

You can actually create a covered call completely from scratch if you want, by first buying the relevant stock and then writing the necessary options contracts. However, it's more commonly used when you have previously bought the stock, and there are probably better strategies to use when you have a neutral outlook on a security that you don't already own.

For the sake of this article, we will assume that you own stock and wish to apply the covered call at a stage when you think that it isn't going to move much in price.

Establishing a covered call is very simple, you just have to write enough calls (using the sell to open order) to cover the amount of shares that you own. You can write these at whatever strike you choose, but traders will usually write them at a strike that is slightly higher than the current price of the shares.

By writing options with a higher strike, you stand to make a higher return if the price of the underlying stock increases, but you will make less if it stays the same. You will also have less protection should it fall.

In terms of choosing an expiration date for the options you write, the general rule is to write them with an expiration that is close, typically at the nearest month. By doing this you stand to benefit from a quick rate of time decay and there's a shorter period of time for the underlying stock to move in price. An example of establishing a covered call is as follows.

• You own 100 shares of Company X stock, which is currently trading at $50.We shall refer to this price as the Starting Point.
• You believe that the price will not move over the next few weeks, and want to profit from that.
• Out of the money calls with a strike of $52 and the closest expiration date are trading at $1.
• You write 1 call options contract (each contract contains 100 options) and receive a credit of $100.

Profiting

The maximum profit is made when, at the time of expiration, the price of the shares increases to the strike of the options written. In the above example, this would be when Company X stock is trading at $52. Should this scenario occur, the options written would expire worthless and you would keep the credit received for writing them and have no further obligation.

Therefore, your profit would be $100. You would, of course, also profit from the shares that you own increasing in value, in this case $2 per share multiplied by 100 shares for a $200 profit. Your total profit would be $300.

The covered call would also return a profit if the price didn't move at all, or increased to a price lower than the strike of the options written. Again, the written calls would expire worthless and you would keep the credit as your profit. You would also still profit from the increase in the value of the stock, if there was any.

The profit potential of this strategy can be summarized as follows.

• Maximum profit is made when “Price of Underlying Stock = Strike of Options”
• Profit is also made when “Price of Underlying Stock > or = Starting Point but < Strike of Options”
• Profit, per share owned/option written, is “(Price of Underlying Stock – Starting Point) + Price per Option”
• The profit calculation does not apply when “Price of Underlying Stock > Strike of Options”

It should be noted that there's a school of thought that says that any profit made from an increase in the price of the underlying security would have been made even without applying the covered call, and it shouldn't be included in the profit calculations.

Potential Risks

There are two main risks when using this strategy. First, it offers very little protection if the stock should fall in value. Any losses incurred from a drop in the value of the underlying stock will be offset only by the credit received for writing the options.

In the above example, if the price fell to $49, then that loss would be covered. However, if it fell any further than $49, then there would be no additional returns from the options. It could be argued, of course, that you would incur those losses just from owning the shares anyway and the covered call does at least give you something in return. You should be very clear, though, that this isn't a suitable strategy if you think there's much chance that the shares will drop significantly in value.

The second main risk is that you won't make any further profits if the stock should rise above the strike of the options written. In the above example, if the price rises above $52, then the calls you have written could be assigned and you'll be forced to sell the stock you own at the strike of $52.

Although this would still mean a profit is made, you would have made more if you had simply held on to the stock and not applied the covered call. As such, this isn't an ideal strategy if you think the price of the stock may increase by a significant amount, although you can always use the buy to close order to buy back the options written if at any point you believe the price is going to increase by more than originally expected.

Summary

The covered call is a great and simple,strategy to use if you own stock that you think is going to be relatively stable in price for a period of time. There's no real cost associated with applying it, and you can effectively generate a return from your stock not moving in price. The main disadvantages are that it can limit your profits if the price goes up unexpectedly high and it offers no real protection against it going down.