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 strategies for investors who want to pursue an income goal to potentially enhance returns. In fact, traders and investors with accounts approved for options trading may even consider covered calls in their individual retirement accounts (IRAs). While the strategy is straightforward, there are important things to know before diving in.

Covered calls explained

First, let’s nail down a definition. A covered call is a neutral to bullish strategy where a trader typically sells one out-of-the-money¹ (OTM) or at-the-money² (ATM) call option 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 moves in the underlying stock price), close or roll³ the call option.

If the call option expires OTM and the trader maintains the position in the stock, they can potentially consider selling another call after the expiration. On the other hand, if the stock moves above the call’s strike price, the call option is in the money⁴ (ITM) and will likely be assigned, requiring the covered call holder to deliver the shares of the underlying stock at the strike price.

If assignment isn’t the desired outcome, the trader can possibly roll the call to a later expiration and possibly a higher strike price or maybe buy the short call back before expiration, potentially taking a loss on the call but keeping the stock. Bear in mind, short options can be assigned at any time up to expiration regardless of the amount in or out of the money. Once assigned, it’s too late to close the position and the stock will be called away, which caps any profitability above the strike price.

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

1. Generate income
2. Reduce the net cost of stock shares

Generate income. Let’s 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 below). For now, let’s look at calls that are OTM, that is, the strike prices are higher than the current underlying stock price.

Some traders take the OTM approach in hopes of lowering the odds of seeing the stock called away. Others choose strike prices closer to the stock price, such as ATM calls, to bring in a larger premium for the calls sold.

Strike selection

From the Analyze tab, enter the stock symbol, expand the Option Chain, and analyze the various options expirations and the OTM call options within the expirations.

As long as the stock price remains below the strike price through expiration, the option will most likely expire worthless. Options are subject to “time decay,” meaning they  decrease in “time” value in the days and weeks and months to come. Of course, much of the value of options is driven by stock price, but not all value. If all other factors were static, this works in favor of the option seller.

With XYZ at $32 per share, a trader might consider selling a 37-strike call (one options contract typically specifies 100 shares of the underlying stock). In doing so, they’re assuming the risk of having to sell the stock for $5 more than the current price in the event of assignment, so they should make sure they’re comfortable with that prospect before entering the trade. But they’ll immediately collect $1.85 per contract ($185) minus transaction fees. That’s in addition to whatever the stock may return during this time frame but only up to $37. If the call expires OTM, they could consider selling another call at a further expiration and potentially a different strike price.

Keep in mind, the price for which a trader can sell an OTM call is not necessarily the same from one expiration to the next, mainly because options with later expirations will have more time value. Different levels of implied volatility (IV) can be a factor as well. All else being equal, when IV is higher, the credit a trader collects from selling the call could be higher as well. But when IV 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 premium received from the short call offsets the long stock’s loss. But if the stock drops more than the premium received from selling the call option, the covered call strategy begins 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 the short calls plus transaction fees. The bottom line? If the stock price tanks, the short call offers minimal protection.

Select strikes accordingly

Notice that the outcome of a covered call often hinges on whether the trader gets assigned, so they need to strategically select the strike price.

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 hold shares rather than risk losing them with a covered call. Conversely, if the underlying stock had a big run and a trader thinks the rally is out of steam, selling a covered call may be a consideration.

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

• Select a strike where they’re comfortable selling the stock.
• Consider a strike price where there’s probable resistance on the chart.
• Evaluate a strike based on its probability of being ITM at expiration by looking at the delta⁶ 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 delta to be a rough estimate of the probability of an option expiring ITM. (Understand that probability calculations are hypothetical and are based on theoretical pricing models. These models use variables that are subject to continuous change.)

Weighing the risks vs. benefits

Because a trader selling a covered call might be giving up the potential for additional profits if stock XYZ rises above the strike price, the strategy is not appropriate if one thinks the stock has potential for significant gains in the near term. But in markets where the trader expects movement more incrementally, this strategy could be useful. Keep in mind, a market that was moving incrementally in the past won’t necessarily continue to do so in the future. Also, if the stock goes up, the call option will typically increase in value as well, and the losses on the short call will offset some or all gains on the stock. But that’s only one feature of this options-based income strategy.

What happens when a trader holds a covered call until expiration?

First, if the stock price is above the strike price, the stock will likely be called away, perhaps netting an overall profit if the strike price is higher than the break-even point, which (excluding transaction fees) is the stock’s purchase price minus the premium from selling the call.

Second, if the stock price moves up near, but below, the strike price at expiration, the trader would likely get to keep the stock as well as the full premium of the now-worthless option.

Third, if the stock falls, the call will likely expire worthless if it is OTM, and the position might show a gain or loss at expiration, depending on whether the premium for selling the call is enough to offset the loss in the stock. The major downside to the trader here is that the trader is typically stuck holding the stock position as it declines. To a long-term investor, this may be a minor consideration, but to a shorter-term trader it could represent a real inconvenience. 

Bottom line

A covered call has some limits because the profits from the stock are capped at the strike price of the option. Another downside is the chance of losing a stock a trader wanted to keep. Some traders hope for the calls to expire so they can sell a covered call 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 right knowledge and tools at one’s fingertips, traders could consider covered call options strategies to potentially generate income.

1. A call option is out of the money (OTM) if its strike price is above the price of the underlying stock.
2. An option whose strike is “at” or nearest to the price of the underlying stock.
3. Rolling refers to closing one option and opening another at a different strike price and/or expiration.
4. A call option is in the money (ITM) if the stock price is above the strike price.
5. Expressed as a percentage in an options-pricing model, implied volatility is theoretically embedded in the options contract’s price and represents the market’s perception about the underlying stock’s future volatility.
6. A measure of an options contract’s sensitivity to a $1 change in the underlying asset. All else being equal, an option with a 0.50 delta (for example) would theoretically gain $0.50 per $1 move up in the underlying stock. Long calls and short puts have positive (+) deltas, meaning they gain as the underlying gains in value. Long puts and short calls have negative (–) deltas, meaning they gain as the underlying drops in value.