Brendan was a Financial Advisor for 10 years and has completed all 3 levels of the CFA Program.
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.
Strategy 2: Earn Additional Income from Premiums
Let's say that when Daniel purchased ABC Inc. stock, he believed it was a good stock to own over the long term and that it would grow in a slow but steady manner. He could benefit from his viewpoint by choosing to sell call options regularly (after each expiry) on ABC Inc. and collecting the option premium. If, as expected, the price does not fluctuate much, and the call options do not get exercised, Daniel will be able to receive a healthy 'Income' from the sale of the call options while still holding on to the stock.
What Is the Downside of Using Covered Calls?
Should ABC Inc. skyrocket to a price of $80 per share, Daniel's gains would be limited to the agreed price of $55 plus the premium he received:
- Net gain = ($5500 + $300) - $5000 = $800
- Gain if Daniel had not used the covered call strategy = ($80 X 100) - $5000 = $3000
Finally, while this isn't a downside of the strategy itself, an investor must consider the risk of the asset price dropping significantly, thus leading to a loss. A covered call strategy can at best provide a bit of protection against loss as we saw earlier. It does not protect against significant price drops.
Depending on an investor's point of view, a covered call strategy can be used to reduce the effective purchase price of an asset or to earn a regular income from option premiums. This isn't a foolproof strategy and should be adopted based on an informed opinion of the underlying asset's future potential and the investor's tolerance of risk.
To unlock this lesson you must be a Study.com Member.
Create your account
Register to view this lesson
Unlock Your Education
See for yourself why 30 million people use Study.com
Become a Study.com member and start learning now.Become a Member
Already a member? Log InBack
Resources created by teachers for teachers
I would definitely recommend Study.com to my colleagues. It’s like a teacher waved a magic wand and did the work for me. I feel like it’s a lifeline.