What is a covered call?
A covered call strategy involves owning the underlying asset and selling a call option on that asset. This means you must sell 100 shares of the underlying asset at the strike price if the option is exercised.
The objective is to generate additional income from the premium received while holding the underlying asset, especially when expecting a minor increase or decrease in its price.
Risk/Reward:
- Risk: Limited since you already own the underlying asset. The main risk is missing out on potential gains if the stock price rises significantly above the strike price. The maximum loss occurs if the stock price falls to zero.
- Reward: Limited to the premium received plus any gain up to the strike price. Maximum profit is reached if the stock price is at or above the strike price at expiration.
Example:
You own 100 shares of XYZ stock trading at $60 per share. You sell the XYZ $65 call option expiring in 45 days for $3.00.
The risk reward of selling the call and owning the 100 underlying shares vs only owning the 100 shares:
- The theoretical max gain is $3.00 per share, or $300 total for the option sold, if XYZ stock price remains below $65 by expiration.
- The theoretical max loss is unlimited as the price of XYZ can increase to an unlimited number. Loss occurs if XYZ rises above $65 on expiration, and the option is exercised against your position. While it isn't an actual loss in that case as you will be selling your owned XYZ stocks that were put as collateral, had you kept you stocks they would have been worth more and thus considered a loss.
- The breakeven point at expiration is $68.00. It’s calculated by adding the premium received ($3.00) from the strike price ($65).
If we look at the risk reward of the full covered call position (i.e., owning 100 shares and and selling the call contracts):
- The maximum profit of a covered call is equivalent to the premium received for the options sold plus the potential upside in the stock between the current price and the strike price. In this example the maximum profit is $8.00 per share or $800 for the total position and is reached if the price of the underlying asset at the strike price or higher
- The theoretical max loss of XYZ is equal to the current price of your shares minus the premium collected. This occurs if the stock price falls to $0 and the total loss would be $5,700 which is the total loss on the position of $6,000 minus the premium received of $300 for selling the options.
- The breakeven point at expiration is $57, equal to the current price of your long stock minus the premium collected. Note that if the strike price of the call is below the current price, you could potentially sell your shares for a loss if they get assigned.
How should I manage a covered call position?
A covered call strategy benefits when the underlying stock price rises, ideally reaching the strike price of the short call. Additionally, if implied volatility drops, the option loses value, assuming other factors remain constant.
Although holding your covered call until expiration is an option, it's not the only way to close the position. There are multiple strategies for closing a covered call. You can either buy back the call to close your position, roll your position, or hold through expiration.
What should I do if my short call is expiring soon?
About 30-45 days before expiration, time decay accelerates, causing the option to lose extrinsic value, which is beneficial for the short call.
As you hold your short call, you'll need to decide whether to buy back your short call, roll it, or hold it until expiration. If the option is profitable, consider taking action before expiration. Many traders choose to close or roll a short call during the expiration week. While you may not keep the entire premium, you can secure a profit on the short call and avoid the risk of having your shares called and assigned, especially if you would like to hold your long stock position.
If the stock price rises above the call’s strike price
- Your shares and short call gain value. However, the higher the stock price goes, the more the short call will offset your stock gains.
- To exit the short call before expiration, you can buy to close or roll it for a loss.
- If you do nothing, your shares will likely be called away at the strike price, with gains on your long stock position offsetting the short call loss.
If the stock price drops
- The call option will lose value (a positive outcome), but your long stock will incur losses (a negative outcome). The further the stock drops, the less sensitive the short call becomes to price changes. At this point, the short call may have little to no value.
- You can exit the short call before expiration by buying to close or rolling it.
What can happen if I hold the covered call at expiration?
If you choose to hold your covered call until expiration, three scenarios can occur:
- Out of the Money: If the stock price is below the strike price, the call option will expire worthless, and you keep the premium received when you sold the call.
- At the Money or Slightly In the Money: If the stock price is at or slightly above the strike price, the call option may be exercised, and your shares will be called away at the strike price. You keep the premium and realize a gain or loss on the stock position based on the strike price.
- Deep In the Money: If the stock price is significantly above the strike price, the call option will almost certainly be exercised, and your shares will be called away at the strike price. You’ll realize a loss on the call but gain on your long stock position.
What should I do if my covered call is assigned?
If assigned, you must sell your shares at the strike price. Ensure you understand the implications of missing out on potential gains.
How can I avoid my cover call from being assigned?
Closing your covered call position before expiration can help manage risks and lock in profits. By buying to close or rolling your position, you avoid the uncertainty of the expiration process and potential losses if the stock price moves unfavorably
Early assignment happens when the buyer of the call option you sold exercises it before expiration. As the seller, you can't exercise the option; only the buyer can. If assigned, you must sell your shares at the call's strike price. This usually occurs when the stock price is well above the strike price, and the option has little to no extrinsic value left and/or there right before a dividend date.
If you're assigned a short call option just before the ex-dividend date. Your shares will be sold, and you won't receive the dividend. To avoid this, consider buying back your short call before the end of trading on the day before the ex-dividend date.