Uncovering the Covered Call: An Options Strategy for Potentially Enhancing Portfolio Returns

The covered call is one of the most straightforward and widely used options-based strategies for investors who want to pursue an income goal as a way to potentially enhance returns. In fact, traders and investors may even consider covered calls in their IRAs. It’s a pretty basic and straightforward options strategy, but there are some things you need to know.

Covered Calls Explained

First, let’s nail down a definition. A covered call is a neutral to bullish strategy where a trader sells one out-of-the-money (OTM) or at-the-money (ATM) call options contract for every 100 shares of stock owned, collects the premium, and then waits to see if the call is exercised or expires. Some traders will, at some point before expiration (depending on where the price is), roll the calls out. 

To create a covered call, a trader sells an OTM call against stock they own. If it expires OTM, the trader keeps the stock and maybe sells another call in a further-out expiration. The trader can keep doing this unless the stock moves above the strike price of the call. When that happens, the trader can either let the in-the-money (ITM) call be assigned and deliver the long shares, or buy the short call back before expiration, potentially taking a loss on that call, and keep the stock. Keep in mind, short options can be assigned at any time up to expiration regardless of the ITM amount.

Traditionally, the covered call strategy has been used to pursue two goals:

1. For most traders, generate income
2. For a much smaller number of traders, offset a portion of a stock’s potential price drop

Generate income. We’ll look at a basic covered call example. Say a trader owns 100 shares of XYZ Corp., which is trading around $32. There are several strike prices for each expiration month (see figure 1). For now, let’s look at the calls that are OTM, that is, the strike prices are higher than the current price of the underlying stock. If the call is assigned and the stock is sold at the strike price, it might as well sell it at a higher price, right?

Some traders take the OTM approach in hopes of the lower odds of seeing the stock called away. Others get calls closer to the stock price, or ATM, to try get a larger credit for the calls. 

As long as the stock price remains below the strike price through expiration, the option will likely expire worthless. Options are subject to “time decay,” meaning they usually decrease in value in the days and weeks to come (all other factors being equal). This typically works in favor of the option seller.

A trader might consider selling a 37-strike call (one options contract typically specifies 100 shares of the underlying stock). The trader runs the “risk” of having to sell the stock for $5 more than the current price, so they should be comfortable with that prospect before entering the trade. But they’ll immediately collect $1.85 per share ($185) minus transaction costs. That’s in addition to whatever the stock may return during this time frame. If the call expires OTM, they could consider selling another call at a further out expiration date.

Keep in mind that the price for which a trader can sell an OTM call is not necessarily the same from one expiration to the next, mainly because of changes in implied volatility (vol). When vol is higher, the credit a trader takes in from selling the call could be higher as well. But when vol is lower, the credit for the call could be lower, as is the potential income from that covered call. 

Please note: This explanation only describes how a position makes or loses money. It doesn’t include transaction fees, and it may not apply to the tax treatment of your position.

Offsetting a portion of a stock price’s drop. A covered call can compensate to some degree if the stock price drops, the short call expires OTM, and the short call’s profit offsets the long stock’s loss. But if the stock drops more than the call price, the covered call strategy can begin to lose money. In fact, the covered call’s maximum possible loss is the price at which the stock was purchased minus the credit(s) from short calls plus transaction costs. The bottom line? If the stock price tanks, the short call offers minimal protection.

Select Strikes Accordingly

Notice that this all hinges on whether the trader gets assigned, so they need to select the strike price strategically.

If a stock’s been beaten down and a trader thinks a rally is in order, they might decide to forgo the covered call. Even though they may be able to buy back the short call to close it before expiration (or possibly make an adjustment), if they think the stock’s ready for a big move to the upside, it might be better to wait. Conversely, if the underlying had a big run and a trader thinks it’s out of steam, then they might more aggressively pursue a covered call. 

Once a trader is ready to pull the trigger, what strike should they choose? There’s no right answer to this, but here are some ideas to consider:

• Select a strike where one is comfortable selling the stock. This is about as old school as it can get.
• Choose a strike price where there’s resistance on the chart. If the stock hits that resistance level and holds steady until expiration, the trade may have hit its full profit potential for that expiration period.
• Pick a strike based on its probability of being ITM at expiration by looking at the delta of the option. For example, a call with a 0.25 delta is read by some traders to imply there’s a 25% chance of it being above the strike and a 75% chance of it being below the strike at expiration. It’s not exact, of course, but some consider it a rough estimate.

Weighing the Risks vs. Benefits

A trader might be giving up the potential for hitting a home run if XYZ rockets above the strike price, so covered calls may not be appropriate if one thinks the stock is going to shoot the moon. But in markets that’re moving more incrementally, this strategy could be beneficial. Keep in mind that if the stock goes up, the call option sold also increases in value. But that’s part of the risk with this options-based income strategy. 

What happens when a trader holds a covered call until expiration? First, if the stock price goes above the strike price, the stock will most likely be called away, perhaps netting an overall profit if the strike price is higher than where the stock was purchased. Second, if the stock price moves up near the strike price at expiration, the trader would likely get to keep the stock and have the gain from keeping the full premium of the now-worthless option. 

A covered call has some limits for equity investors and traders because the profits from the stock are capped at the strike price of the option. Another downside here is the chance of losing a stock a trader wanted to keep. Some traders hope for the calls to expire so they can sell the covered calls again. Others are concerned that if they sell calls and the stock runs up dramatically, they could miss the up move. 

Covered calls, like all trades, are a study in risk versus return. With the tools available at one’s fingertips, traders could consider covered call options strategies to potentially generate income.