Breaking Down How Covered Call Options Work
Vineel Bhat | 08/05/22
Options as a Whole
In some ways, options are like stocks, commodities, and other assets: they trade on a market, their value fluctuates, and you pay taxes on any gains you make from them. However, options are not assets – rather, they are contracts which trade based on the price of existing assets like stocks and commodities. For example, an option on a stock will change in value as the price of the stock does, but by a different magnitude and potentially in a different direction. Further, unlike stocks, options have characteristics other than their price/value given by the market. These include levels for the underlying asset (also known as the strike price), the date at which the option expires, and whether it’s a put or call option. A $180 call option on Apple which expires next week is a different than a $160 call option on Apple which also expires next week, for example. Typically, hundreds of options can exist for a given asset with varying strike prices, expiration dates, and types. In order to understand covered call options, we will first dive into call options specifically, both buying and selling, then cover how the covered call variation differs and provides investors unique opportunities (and risks).
Buying Call Options
Call options are one of the two types of options (the other being put options). When concerning the stock market, the textbook definition is that a call option is the right to buy 100 shares of a stock at a certain price. Quite literally, you are paying for the “option” to buy shares of a stock at a certain price. Why buy a call option to buy a stock when you can buy the stock itself on the stock market? Well, it’s because they provide leverage – you can make a lot more money if the stock goes up enough/stays high enough, or lose everything otherwise. There are no hassles like borrowing money and paying interest. Feel’s like gambling right? It kind of is (unless used strategically).
For example, let’s say XYZ stock trades at $60 a share. Instead of buying 100 shares of XYZ stock for $6,000, you buy a call option for $100 which gives you the right to buy 100 shares of XYZ stock at $60 a share before the end of the month. If shares of XYZ stock rose to $66 by the end of the month, you would have made 10% ($6,000 -> $6,600) by simply holding the shares. However, the call option would have made you 500% ($100 -> $600): the option to buy each share at $60 when XYZ stock is trading at $66 is worth $6, and since each option is a contract for 100 shares, you can sell/close the option on the options market for $600. Instead, if shares of XYZ stock fell to $54 by the end of the month, you would have lost 10% ($6,000 -> $5,400) by simply holding the shares. However, the call option would have lost you 100% ($100 -> $0): the option to buy each share at $60 when XYZ stock is trading at $54 is worthless; zero times a hundred is still zero, so you won’t be able to sell the option on the options market and it will expire worthless.
Clearly, the options market is very volatile (and so buying call options can be highly profitable or the opposite). But it is also very efficient, meaning what you pay for an option in the options market is based on the probability of the stock price going up a certain amount. Of course, it isn’t free money being tossed around!
The higher the strike price of the call option (the price at which you pay for the right to buy 100 shares at), the cheaper the call option is to buy, since there is a higher probability of it becoming worthless if the stock price doesn’t go above the strike price. Conversely, the lower the strike price of the call option, the pricier the call option is to buy, since there is a lower probability of it becoming worthless as the stock price needs to go up less, or can even go down and still be above the strike price. Strikes higher than the current price are known as “out of the money,” or “OTM” options; strikes lower than the current price are known as “in the money,” or “ITM” options; and strikes exactly at the current price are known as “at the money,” or “ATM” options. Other factors also influence the price of options, like the time till expiration (more time = higher price) and volatility of the underlying stock/asset (higher volatility = higher price).
The max profit possible on buying a call option is unlimited (the higher the price of the underlying stock goes), while the max loss possible is limited to the amount payed (no matter how much the underlying goes down, the option is simply worthless). Given the $60 call option on XYZ stock which expires at the end of the month, mentioned earlier, this is a chart of how the profit/loss for buying the option would look like depending on the price of XYZ stock at the end of the month:
Source: Invessential.com
If the price of XYZ stock ends below $60 at the end of the month, you lose the full $100 paid for buying the option contract: there is no value in being able to purchase 100 shares of XYZ stock at $60 when the market price is lower. If the price ends between $60 and $61, you lose an amount between $0 and $100: although there is value in being able to purchase 100 shares of XYZ stock at $60 when the market price is slightly higher, the difference is less than $1 per share, or less than $100 in total, resulting in a net loss. Finally, if the price ends above $61, you make a profit depending on how high the stock went: the difference between the market price and $60 (the price at which you have bought the right to buy 100 shares) is greater than $1, or $100 in total, resulting in a net gain. In the event of a large move up, this gain could be enormous.
Buying call options allows investors to capitalize big on sizeable gains in stock price – multiples more than simply buying shares of the underlying stock. However, they are speculative for this same reason: high risk, high reward.
Selling Call Options
Selling call options takes the opposite side: as a seller, you provide a buyer the right to buy 100 shares of stock at a certain price in exchange for a sum of cash, also known as the premium. Premium is the total price of the option, or 100 multiplied by the price of the option per share. While premium is income for call option sellers, it’s a cost for call option buyers. This works just like it does in the stock market: the price of the stock multiplied by the number of shares being traded is income for the seller but a cost for the buyer. Back to options, in exchange for income, as a seller, you take on a level of risk. If the price of a stock goes above the agreed upon price at expiration, you will have to purchase shares at the higher market price and sell them to the buyer at the agreed upon price. However, if the price of a stock stays below the agreed upon price at expiration, you pocket the cost payed by the buyer and the option ends up worthless, as explained previously.
To illustrate further, let’s go back to the example of XYZ stock, which trades at $60 a share. You decide to sell a call option expiring at the end of the month for $100, which obligates you to sell 100 shares of XYZ stock at $60 a share whenever the buyer chooses to exercise their right, which is usually right at expiration. If shares of XYZ stock fell to $54 by the end of the month, you would have made $100 – the amount you received from the buyer in exchange for the call option. The call option would expire worthless as the option to buy 100 shares of XYZ stock at $60 a share when XYZ stock is trading at $54 is worthless. Instead, if shares of XYZ stock rose to $66 by the end of the month, you would have lost $500. The option buyer would exercise their right to buy 100 shares at $60 a piece because they could sell them at the current price for a profit. In order to garner the 100 shares which you must sell to the option buyer, you buy them at the market price of $66, and sell them for $60. While you recieve $100 in exchange for the option, you lose $600 because you lost $6 on each of 100 shares, resulting in a net loss of $500. These situations – and selling as a whole – are the opposite of the buying side.
The max loss possible on a selling a call option is unlimited (the higher the price of the underlying stock goes), while the max profit possible is limited to the premium received (no matter how much the underlying goes down, the option is simply worthless). Given the $60 call option on XYZ stock which expires at the end of the month, this is a chart of how the profit/loss for selling the option would look like depending on the price of XYZ stock at the end of the month:
Source: Invessential.com
If the price of XYZ stock ends above $60 at the end of the month, you take a loss depending on how high the stock went: the difference between the market price and $60 (the price at which you have sold the right to buy 100 shares) is greater than $1, or $100 in total, resulting in a net loss AFTER adding the $100 received. A large move up, opposite to buying call options, could lead to an enormous loss. If the price ends between $60 and $61, you gain an amount between $0 and $100: although there is value to the buyer in being able to purchase 100 shares of XYZ stock at $60 when the market price is slightly higher, the difference is less than $1 per share, or less than $100 in total, resulting in a net gain for you (the seller). Finally, if the price ends below $60 at the end of the month, you gain the full $100 received for selling the option contract: there is no value for the buyer in being able to purchase 100 shares of XYZ stock at $60 when the market price is lower.
Selling call options allows investors to make income in a different way compared to traditional dividends. The amount of income can be very large, depending on the strike price at which the option is sold. However, they are also speculative because your potential losses are unlimited as the price of the underlying stock increases.
Selling Covered Call Options
Selling covered calls, or just covered calls, are a variation of selling regular calls (also known as naked calls). They can reduce the risk of losses from selling the call option itself, and provide the same income a naked call option would. However, there are also downsides to the variation, such as opportunity cost.
Selling one covered call option means selling one call option on a stock which you own at least 100 shares of. Instead of having to buy shares and sell them at a loss if the price of the underlying stock exceeds the strike price, you can simply sell the shares you already own. However, you miss out on additional gains from selling the shares at the market price rather than to the option buyer at the lower strike price.
Let’s go back to the example of XYZ stock for the final time. You buy 100 shares of XYZ stock at $60 a share, and also sell a $60 strike call option expiring at the end of the month in exchange for $100 in premium. No matter where the stock price is at during the end of the month, you keep that $100 premium as income. If the price goes below $60, just like with selling a naked call option, nothing happens: you make a net gain because of the premium and keep your shares. If the price goes to between $60 and $61, the option buyer will exercise her/her right to buy 100 shares at $60 as they can make a profit. But instead of having to buy the shares at the higher current price and sell them at the lower price, you simply sell your existing 100 shares purchased at $60 per share for neither a loss or gain. You make a net gain because of the $100 premium. If the price goes above $61, the same situation plays out and you make the same net gain, as you sell your existing shares at the same price they was bought at. Covered calls seem like a free money hack! Except… they’re not – here are the limitations.
If the price of the underlying stock goes above the strike price, you are losing out on some of the gains in selling your existing shares, as you have to sell them at the lower strike price. Additionally, the sale of covered call options require a significant investment of capital. To employ the covered call strategy, you must put down 100 shares of stock, compared to which the net gain can be minuscule. This net gain may be lower than simply placing the cash pile elsewhere.
Selling covered call options allows investors to make income like in naked call options, but takes away some of the risk in doing so. If shares of the underlying stock are bought at the same/lower price compared to the strike price, covered call options can eliminate all risk of losses in the contract. In exchange, you cap your upside and invest additional capital.
Conclusion
Covered call options are an intriguing tool investors can use to generate income from stocks they already hold. But, it’s important to understand the primary drawback: the cap the call places on potential gains on the investment. If shares of the underlying are being bought purely for the purpose of selling covered calls on them, it should be considered that the profits from covered call options can be a very small amount of the original capital invested on an annual basis.
The options market is more efficient than it is inefficient. Option prices reflect the probabilities of the underlying stock’s movement before the expiration date – with staggering accuracy – which makes it hard to profit from trading them. While options are often considered a zero-sum game, selling covered call options may not fall into the same bucket because of the position in the underlying security component. Some indices and ETFs which have made use of covered call strategies in a systematic fashion have been able to achieve total returns on par with the market over a long period of time, and in some instances, returns either above the market or returns superior when adjusted for volatility.
Cheers, and happy investing!
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Disclaimer: Opinions not advice! I am not a registered financial advisor. All views and recommendations expressed in this article are solely my opinions and should not be considered as financial advice.