How to use a covered call options strategy
Covered call options strategies are popular because they enable traders to hedge their positions, and potentially generate additional profit. Discover what a covered call is and how it works.
What is a covered call?
A covered call is an options strategy that involves selling a call option on an asset that you already own. The call option is ‘covered’ by the existing long position, as should the buyer (holder) of the call option decide to exercise the contract, you could deliver the security in question.
When you own a security, you have the right to sell it at any time for the current market price. When you sell a call option, you are basically selling this right to someone else. The holder of your call option would have the right to buy your security on the option’s expiry date for a predetermined price – called the strike price.
In return for taking on the risk of selling an option, you’d be paid a premium. This cash fee is paid on the day the options contract is sold – it is paid regardless of whether the buyer exercises the option.
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Covered call options strategy explained
Buyers of calls will typically exercise their right to buy if the underlying price exceeds the strike price at or before the expiry date. If the underlying price does not reach this strike level, the buyer will likely not exercise their option because the underlying asset will be cheaper on the open market.
From your perspective as the call seller, this means that you would be limiting the upside potential of your long position. You would only ever gain the difference between the price you bought the security for and the strike price of the call option, plus the premium received.
The maximum profit that a covered call can make is calculated as follows:
(The call option’s strike price – the purchase price of the underlying stock) + the premium received for writing the call = covered call profit
However, a covered call does limit your downside potential too. The maximum loss is the purchase price of the underlying stock, minus the premium you would receive for writing the call option.
How and when to sell a covered call
Covered calls are primarily used for two reasons:
- To make money when the market is inactive
- To offset loss to your existing long position
A covered call is a ‘neutral’ strategy, which means it is used when little movement is expected in the underlying market. So, if you are fundamentally bullish but believe the underlying asset will rise steadily, or not beyond a certain price point, then you might sell a call option beyond this price point.
You’d only do this if you were fairly confident that the buyer of the option wouldn’t exercise the option by the date of expiry due to the market not moving beyond the strike price. This means that you would get to keep your security and you’d also receive the option’s premium.
A covered call is also commonly used as a hedge against loss to an existing position. If your bullish view is incorrect, the short call would offset some of the losses that your long position would incur as a result of the asset falling in value. You could sell your holding and still have earned the option premium.
Covered call example
Let’s suppose you own 100 shares in company ABC, which you bought for £40 per share (a total of £4000). You believe the shares have a strong chance of generating profit in the long term but in the short term you expect the share price to fall, or to not increase dramatically, from the current price of £50.
As a result, you decide to sell a call option on the same number of ABC shares with a strike price of £60. You’d earn a premium by selling this call option. If we assume that the premium for this call option is 100p per share, you’d receive a total premium of £100 regardless of whether the option is exercised.
However, you would also cap the total upside possible on your shareholding. You would make a profit for all gains up to a share price of £60, after which point the call option is ‘in the money’ so is likely to be exercised by the buyer. This means you’ll have to sell your underlying shares. Your shareholding would only generate £20 profit per share (the difference between the initial purchase price and the strike price).
So, the maximum you’d gain from this covered call is £2100 (the £100 premium, plus £20 profit for each of your 100 shares).
How the Greeks affect covered calls
The Greeks help traders estimate the likely changes in an option’s value based on different factors that can impact it throughout its lifespan. The Greeks that call options sellers focus on the most are:
Delta is how much an option’s price moves for every point of movement in the underlying market. For example, a call option that has a delta of 0.5 would increase by 0.5 for every point of movement in the underlying market.
Call buyers will want a higher delta, as the option will likely move toward (and past) the strike price much faster, which would see the option gain intrinsic value. But as a call seller, you’d want an option with a low delta, so that underlying price movements have a much lower impact.
Theta, also known as time decay, is a measure of how much an option’s value declines over time.
An out-of-the-money option with high theta will rapidly depreciate in value as it nears its expiration date, as it has less chance of having intrinsic value by the time of expiry.
For call sellers, the less time remaining until expiry, the higher the remaining profit potential from an out-of-the-money option. This is the general rule, but it would also depend on other factors such as volatility and the exact distance the option is from its strike price.
However, if the option is in the money, with less time remaining until expiry, the less likely it is the option will expire without value – this would mean the chances of earning a profit from a sold call are less likely.
Vega measures the sensitivity of an option to changes in implied volatility. For example, an option with a vega of one will move one point when its underlying market’s implied volatility changes by 1%.
Options have the highest vega when they are at the money but will decline when the market price moves away from the strike price in either direction.
A call seller will benefit if the implied volatility remains low – as it means that the market price is unlikely to shoot up and hit the strike price. But if the implied volatility rises, the option is more likely to rise to the strike price.
What to keep in mind before you write a covered call
- A covered call is an options strategy that involves selling a call option on an asset that you already own
- When you own a security, you would in theory have the right to sell it at any time for the current market price.
- When you sell a call option, you are basically selling this right to someone else in exchange for a premium
- You would cap your profit at difference between the price you bought the security for initially and the strike price
- If the market priced increased beyond the strike price, the buyer could be expected to exercise the option and you would have to sell the underlying stock
- Covered calls are used in neutral markets and for hedging
Ready to start trading options? You can open a live account to trade options via CFDs today. Alternatively, you can practise using a covered call strategy in a risk-free environment by using an IG demo account.
Remember, when you trade options using CFDs, you are speculating on the underlying options price, rather than entering into a contract yourself. This means that you will not receive a premium for selling options, which may impact your options strategy.
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