Lesson 9: The covered call

In a covered call strategy, you own shares of a stock or ETF and sell a call option on those shares. The shares become the linked or underlying asset for the covered call. In general, one call can be sold for each 100 shares owned. When you do this trade, you take on the obligation to sell your 100 shares at the option’s strike price if the option is exercised by the option buyer. You’ll receive a cash credit in your account when you sell the call, which is equal to the premium you sell the call for, less commission on the trade. If the call purchaser doesn’t exercise the call and it expires, you keep your shares as well as the premium you received from selling the call.

As the seller, you have no control over whether your call is exercised — the call buyer decides when and if to exercise the option, up until the option’s expiration date. However, the call buyer’s decision is almost always based on the price movement of the linked stock. That stock price is what ultimately determines the overall profit or loss of the trade.

Executing as a single-leg strategy

• In this trade style, you already own the underlying shares and sell call options against those shares.
• Alternately, you can submit an order to buy shares, wait for that order to be filled and then sell the call options.
• This is also known as “legging in” to a strategy.

Executing as a multi-leg strategy (MLS)

• When both parts of the trade are submitted as one, the trade is known as a buy-write. You are buying the shares and writing/selling a call against them.
• A buy-write is a multi-leg trading strategy. You’ll specify the net price you want to pay: the cost to you of the shares you are buying minus the premium you receive from writing/selling the call. Because a buy-write is a multi-leg strategy, both parts of the trade have to be filled at the same time, at the price you specify or better. If those conditions aren’t met, the trade won’t execute. In essence, it’s a form of contingent order: both parts get filled or neither do.

Investors typically use this strategy when they believe the underlying stock price will rise moderately, remain stable, or drop slightly.

There are several possible reasons to use a covered call strategy. The main reasons are:

• To generate income by collecting the option premium.
• To create a partial hedge against stock losses if the underlying stock price drops. The premium collected from selling calls can lower the cost of the owned shares.

Usually, the main goal of a covered call is to generate income. If the stock price remains below the strike price by expiration, you’ll keep the premium and keep the stock. However, selling a covered call involves a trade-off. If the stock price rises above the strike price, you’ll almost certainly be obligated to sell the shares at the strike price, capping your potential profit.

Typically, a covered call is opened by selling an out-of-the-money call option. Remember, a call is out-of-the-money when its strike price is higher than the underlying stock’s current price and in-the money when the strike price is lower than the current stock price. Although you’ll collect more premium up front for an in-the-money call, you may be at risk for an early assignment or have dividend risk. Details can be found in the following section.

It’s prudent to choose an option with a fairly small bid-ask spread, good daily volume and good open interest.

Before expiry

Time decay, or time erosion, happens continuously for an option and becomes more pronounced as expiration approaches. Time decay is favourable for you when you’ve sold (shorted) a call to open. This means that, all else being equal, the value of a call option declines as time passes and, as a result, your liability as the call seller also declines. This happens even if the stock price doesn’t move.

A drop in the stock price is another positive for the option side of the covered call trade but you’ll also experience a drop in the price of your stock holding. This is why a covered call provides some limited downside protection for the holder of the underlying stock. If the stock price drops dramatically, the extra premium gained from selling the call option might not be enough to offset the loss.

If the stock price moves higher, the call’s price is likely to increase. Because you’re short the call, your liability on the short call increases as the stock price moves up. You’ve been paid the call’s premium in exchange for taking on the obligation to sell your stock at the call’s strike price on or before expiry. Once the market price of the stock is higher than the call’s strike price, your obligation means you are no longer benefiting from the stock’s appreciation. You can buy back the call, closing the short call position and removing your obligation before expiry, a trade called a “buy to close”, but you may have to pay more to do that than you initially took in when you shorted it.

A drop in implied volatility will generally cause a call option to lose value, a positive for you as the option seller if you’ve already shorted the call — it will be cheaper to buy back if you decide to close out the position before expiry. Conversely, a spike in implied volatility will almost certainly push the option price higher, a negative for option sellers who are already short calls. Implied volatility can increase before an earnings release, for example, then drop substantially if the announcement contains no major surprises and the stock price has little reaction. Implied volatility could also increase after the announcement if the stock reacts with more volatility than previously expected.

At expiry

When you’ve shorted an out-of-the-money call, the ideal scenario on expiry day is the stock price closes slightly below the chosen option strike price. If this happens, the call option will usually expire worthless, the chance that you will be exercised is extremely low and you’ll keep your stock. You’ll also keep the full option premium. Many covered call sellers pick a strike price just slightly above the current stock price. In that situation, a covered call strategy benefits the most when the underlying stock price rises slightly, though not so much that it goes higher than the strike price of the call you’ve sold.

If the stock price is above the call’s strike price at expiry, also known as the option being in-the-money, your shares are almost certainly going to be assigned or called away. As described previously, you’ll receive the option’s strike price as your price for selling your shares and you’ll keep the option premium you initially received. Note that there might be additional tax implications if the stocks were held in a non-registered account and have historical capital gain or loss associated with them.

You can also roll your position. Rolling a short call involves buying back your existing short call, realizing any gains or losses, and simultaneously selling a new call option with a later expiration date and/or a different strike price. This allows you to establish a similar covered call position, while managing your risk prior to expiration. This is a common way to maintain your long stock position while trying to avoid assignment on your short call.

Even if you don’t plan to roll your position immediately, you might still wish to close your short call position prior to expiry so that you control the outcome of the trade.

You should be aware of early assignment risk and dividend risk when executing covered calls. Early assignment can occur when the holder of the short call exercises it before expiration, resulting in your obligation to sell the shares at the call's strike price. This typically occurs when the stock is well above the strike price of the call, known as an option that is deep-in-the-money.

Dividend risk refers to the potential assignment of a short call option right before the ex-dividend date, with the result that you’ll lose out on the dividend. This typically happens when the call option is deep in-the-money. You can try to avoid this by buying back your short call before the end of the regular hours trading session the day before the ex-dividend date.

Corporate actions like stock splits, reverse stock splits, mergers, or acquisitions can affect the underlying stock and, consequently, the option's structure, price, or deliverable. Be sure to stay informed about any corporate actions that may impact your covered call position. You can do this by regularly checking both your account holdings and any news on the stock.

A covered call differs from a naked call strategy in that it involves selling an option while owning the underlying shares and therefore has defined risk. A naked call writer does not own the underlying shares and therefore has undefined risk.

Next up is Lesson 10. What is a married put strategy.