General Overview Of Covered Calls

Introduction To Covered Calls

A covered call is a strategy that involves holding onto an underlying security and writing a call option against it.

When a trader writes a covered call, he gets to keep the premium of the call options which he shorts. In this way, the trader collects premium while holding onto the stock. This premium which he collects essentially lowers his average cost of owning the underlying security in which he has bought. On the other hand, you can think of the premium collected as “rent” if the trader writes a call against his stocks monthly.

Disadvantage Of Covered Call

The disadvantage to the covered call strategy is that his profits are capped and limited. When the price of the underlying security rises, he may be assigned to sell his shares to the call option holder.

Rights Of Covered Call Holder

Investors or traders who use the covered call still have ownership rights to owning stock in the underlying security. For example, they are still eligible to receive dividends, vote and participate in a rights issue as they are shareholders of the company( publicly traded underlying security). They may be long term investors who see upside in the long term. But in the near term, they believe that the underlying security may move sideways or stagnate.

How To Execute A Covered Call?

For every 100 shares of an underlying security owned, sell a call option contract on the same underlying security.

Coca Cola Co.

This is a one year chart of Coca-Cola Co. It is currently trading at a current price of $41.96. From, the charts, you should be able to tell that Coca-Cola is trading in a sideways market. This if of course debatable as technical analysts will have different interpretations. But for the sake of education, let us take a look at this real world example. Real world examples at the same time are rarely as perfect as textbook examples.

Coca-Cola is trading between a band of $37.50 and $45. At a price to earnings ratio of 27 and no near term catalyst, you believe that the stock will not trade above $45. But over the next 12 months, the longer term trend tells a different story. It could hit $55.

A covered call

You then decide to buy 100 shares of the stock at a price of $41.96 and sell a December 43 out of the money call option at a premium of $27. Over the life of this option, the stock never trades above $43 and you get to keep the premium of $27. You have just collected “rent” on your stock.  You may choose to write a call against your stock again the next month and collect premium(rent) on your holdings again. You may do so till you feel that the stock is ready to make a price move to the upside. You stop writing calls and you go long on the underlying security only. The price of the underlying security increases and you profit from it.

Types of covered calls

2 types of covered calls – In the money covered calls and out of the money covered calls

Covered calls with out of the money call options

Also known as out of the money covered calls, a trader can sell out of the money call options against the ownership of the underlying security. Compared to writing in the money call options, the premium collected from writing out of the money call options is less. If the price of the underlying security does go up, there is limited profit. Read Out of the money covered calls to appreciate the risk/reward profile of the strategy.

Covered calls with in the money call options

Also known as in the money covered calls, a trader can write in the money call options against the ownership of the underlying security. The premium collected is a lot more when a trader writes in the money call options versus writing out of the money call options because in the money options are worth a lot more. However, covered calls with in the money options have a smaller potential profit than covered calls with out of the money call options.

Read next : Execute an In the money covered call

Also read : Writing Out-Of-The-Money covered calls