What Is a Covered Call?
A covered call is an options strategy you can use to reduce risk on your long position in an asset by writing call options on the same asset. Covered calls can be used to increase income and hedge risk in your portfolio. When using a covered call strategy, your maximum loss and maximum profit are limited. test
Key Takeaways
- A covered call strategy involves writing call options against a stock the investor owns to generate income and/or hedge risk.
- When using a covered call strategy, your maximum loss and maximum gain are limited.
- Sellers of covered call options are obligated to deliver shares to the purchaser if they decide to exercise the option.
- The maximum loss on a covered call strategy is limited to the price paid for the asset, minus the option premium received.
- The maximum profit on a covered call strategy is limited to the strike price of the short call option, less the purchase price of the underlying stock, plus the premium received.
Basics of a Covered Call Strategy
When selling a call option, you are obligated to deliver shares to the purchaser if they decide to exercise the option. For example, suppose you sell one call option contract with a strike price of $15 for stock XYZ. The call option expires one week from today. If the stock price closes above $15 at the expiration date, you are obligated to deliver shares of XYZ to the buyer of the option.
The seller of a covered call gets paid a premiumin exchange for giving up a portion offuture potential upside.
Pros and Cons of Covered Calls
Pros
Generates additional income on shares you may already be holding in your portfolio.
Creates potential profit on stocks that have been trading sideways.
Secures capital when you sell call options. The cash you receive from optioning the position is yours regardless of whether the option is executed.
Cons
Limits your profit potential should the stock price close above your covered call strike price.
Protects against losses does not guarantee a loss will be avoided. A covered call will only minimize your loss.
Compounds losses if the stock price drops and you want to sell your position. If you need to buy your call options back, this may create further losses.
Determining the Maximum Loss on a Covered Call Strategy
The maximum loss on a covered call strategy is limited to the investor’s stock purchase price minus the premium received for selling the call option.
Covered Call Maximum Loss Formula:
Maximum Loss Per Share = Stock Entry Price - Option Premium Received
For example, let’s say you are long 100 shares of stock in company TUV at a price of $10. You think the stock will rise to $15 in six months and are willing to sell the stock at $12. Assume you sell one TUV call option with a strike price of $12 expiring in six months for $300.
Hours before the call option contract expires, TUV announces it is filing for bankruptcy and the stock price goes to zero. Your maximum uncovered call would have been the entirety of your investment ($1,000). However, since you received a premium of $300 for the call option, your loss is reduced to $700 ($1,000 cost basis - $300 call option premium).
Determining the Maximum Profit on a Covered Call Strategy
The maximum profit on a covered call position is limited to the strike price of the short call option less the purchase price of the underlying stock plus the premium received.
Covered Call Maximum Gain Formula:
Maximum Profit = (Strike Price - Stock Entry Price) + Option Premium Received
Suppose youbuy a stockat $20 and receive a $0.20 option premium from selling a $22 strike price call. You then decide to maintain your position providing the stock price stays below $22 until the options expire. If the stock price increases to $23, your profit on the sale of the stock is limited to $2 as the $22 strike price of the option limits your potential upside, Your maximum profit is $2.20 per contract: $2 ($22 strike price - $20 stock entry price) + $0.20 option premium.
Are Covered Calls More Profitable?
Covered calls are a hedging strategy to reduce investment risk. In exchange for minimized risk, covered calls also minimize potential gains.
What Are the Benefits of Covered Calls?
Covered calls are strategically positioned to minimize the amount of losses an investor may experience. Investors benefit from covered calls by having their potential downside exposure of an investment limited.
How Do You Calculate Maximum Loss on a Covered Call?
The maximum loss per share on a covered call is calculated by subtracting the option premium received from the initial investment in the stock.
FAQs
Key Takeaways
What is the maximum profit loss on a call option? ›
Profit/Loss
The potential profit is unlimited, while the potential losses are limited to the premium paid for the call. Although a call option is unlikely to appreciate a full dollar for every dollar that the stock rises during most of the option's life, there is in theory no limit to how high either could go.
What is the maximum profit on a covered put? ›
Since investors selling covered puts are selling their downside, an investor's max profit will cap when the underlying drops below the covered put's strike price, as illustrated where the green profit zone flattens. Theoretically, a short stock position has unlimited losses since it can continually rise in perpetuity.
Can you lose money on a covered call? ›
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.
How much can I make with covered calls? ›
Covered calls can be a powerful tool for generating passive income and reducing the risk of your investment portfolio. By choosing the right stocks and options, you can generate consistent monthly returns of 2% to 4% per month.
How much can you lose with options? ›
Like other securities including stocks, bonds and mutual funds, options carry no guarantees. Be aware that it's possible to lose the entire principal invested, and sometimes more. As an options holder, you risk the entire amount of the premium you pay. But as an options writer, you take on a much higher level of risk.
What is the max loss on Robinhood options? ›
The theoretical max loss is equal to the cost basis of your shares minus the premium collected. This occurs if the stock price falls to $0. Like any stock owner, you risk losing the entire value of the investment—except when you sell a covered call, you would keep the premium you received up front.
Is selling puts better than selling covered calls? ›
Even though a covered call and a short put have the same risk, the ability to manage this risk is much better in a covered call than a short put. For investors looking to repair their losing strategies rather than just take a loss at the first sign of trouble, the covered call is the better strategy.
Why are covered calls bad? ›
Why Are Covered Calls Bad? Covered calls are not necessarily bad. It is recommended not to write covered calls for stocks with high growth potential. The reason is that the upside gain will be missed because you'll be required to sell at the strike price.
How does a poor man's covered call work? ›
In a traditional covered call, an investor must buy 100 shares of stock before shorting an out-of-the-money (OTM) call option against the shares. In a poor man's covered call, investors replace the shares of stock with a deep in-the-money (ITM) long call that has a longer expiration term than the short call.
Income potential: When you write a covered call, you get a premium in return. If the buyer never exercises the option because the strike price isn't attractive, you get to keep that premium — and you don't have to sell your stock.
When should you not sell covered calls? ›
You usually wouldn't want to sell covered calls when the market is very undervalued, for example. Covered calls are a useful tool, and in the hands of a smart investor in the right circ*mstances, can be tremendously profitable.
Can I live on covered calls? ›
Income – Covered calls can provide regular income to supplement retirement income and help cover living expenses. You can even write covered calls on dividend stocks. Low Risk – Selling call options can help minimize downside risk by creating a buffer if the stock price declines.
What is the maximum loss on a long put? ›
The maximum loss is limited. The worst that can happen is for the stock price to be above the strike price at expiration with the put owner still holding the position. The put option expires worthless and the loss is the price paid for the put.
What is the maximum loss on a short put? ›
Profit/Loss
The maximum loss for a short put strategy is unlimited as the stock can continue to move against the trader, at least until it reaches zero.
Can you lose more than 100 in options? ›
If you buy call or put options, the most you can lose is the dollar amount that you spend. Suppose XYZ stock is currently trading at $50, and you purchased one call option contract on XYZ stock with a strike price of 53 at a premium of $5 per contract.
What is the maximum loss on a call spread? ›
The Maximum Loss of a Bull Call Spread
The maximum loss is the net premium paid for the options (i.e., the cost of the call option bought minus the premium received for the call option sold). Based on the example above, it would be $3 minus $1 which is $2.
What is the maximum loss on a short call? ›
Disadvantages of Short Calls
The maximum loss is unlimited because the price of the underlying stock may rise indefinitely.
