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Covered Call: Strategy & Examples

Instructor: Brendan Verma

Brendan was a Financial Advisor for 10 years and has completed all 3 levels of the CFA Program.

Let's take a closer look at one of the most frequently used option strategies, covered calls. Although it is relatively simple, understanding its benefits and drawbacks will help you determine if it's right for you!

What Is a Call Option?

A call option is a financial contract that gives the buyer the right to buy an underlying asset at an agreed price (strike price) on or before a specified date (expiration date).

What Is a Covered Call?

A covered call is a call option that is 'covered' i.e. the seller of the call option holds the required amount of the underlying asset to deliver to the option buyer and fulfill their obligation in the event the option is exercised.

Let's see how this works. Daniel owns 100 shares of ABC Inc. At the same time, he has sold a call option on ABC Inc. On expiry of the option, ABC Inc is selling for more than the strike price. As a result, the option is exercised, and Daniel must deliver 100 shares of ABC Inc to the option buyer. Since Daniel already owns 100 shares of ABC Inc, he does not need to buy them in the market to fulfill his obligation. This protects Daniel from the risk that the market price could have been much higher than the option strike price.

Why Use Covered Calls?

Covered calls provide the following benefits to the option seller:

  • No uncertainty about the payoff if the option is exercised at maturity since the underlying asset is already owned
  • Premium collected from the sale of the call option

Earlier, we looked at how Daniel was safeguarded from the uncertainty of the stock's price on expiry of the option. Now let's examine the benefits from the premium.

Remember the 100 shares of ABC Inc. that Daniel owned? He purchased them at a price of $50 per share for a total cost of $5000 ($50 X 100). Here are the details of the call option he sold on ABC Inc:

  • Strike price: $55
  • Premium collected: $300

On or by the expiration date, if the market price of ABC Inc. is greater than $55, and the option buyer chooses to exercise the option, Daniel will be obligated to deliver 100 shares of ABC Inc (standard options cover 100 shares per contract) to the option buyer. In return, he will receive $5500 ($55 X 100). If however, the stock price is $47, Daniel's holding will be worth $4700 ($47 X 100), the option will not be exercised, and Daniel will continue to own 100 shares of ABC Inc.

Let's examine this transaction closely:

  • Purchase price of 100 shares of ABC Inc. = $5,000
  • Premium from sale of call option = $300
  • If stock price is above $55, proceeds from sale of 100 shares of ABC Inc. = $5,500
  • If stock price is $47, the value of Daniel's holding = $4700

Let's use these numbers to describe the two main strategies (or reasons) for using covered calls!

Strategy 1: To Lower the Cost of Purchase

By selling a call option on ABC Inc. Daniel received a premium and thus lowered his effective purchase price of ABC Inc. stock to:

$5,000 - $300 = $4,700

Investors often use a 'buy-write' strategy wherein they buy a stock and 'write' or sell options to earn a premium, thus lowering their effective cost of purchase. Should the price of the stock or asset drop subsequently, the investor suffers less of a loss due to the lower cost. If ABC Inc. falls to $47 per share, Daniel's holding will be worth $4700. As a result, his loss will be zero. In effect, Daniel has built some protection against loss by selling the call option.

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