Covered Call Writing Of Equity Options

What is a Covered Call?

A covered call is a risk management and an options strategy that involves holding a long position in the underlying asset (e.g., stock Stock What is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company's residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably. ) and selling (writing) a call option on the underlying asset. The strategy is usually employed by investors who believe that the underlying asset will experience only minor price fluctuations.

Covered Call

The main advantage of the covered call strategy is that an investor receives a guaranteed income Rate of Return The Rate of Return (ROR) is the gain or loss of an investment over a period of time copmared to the initial cost of the investment expressed as a percentage. This guide teaches the most common formulas as a premium from the sale of a call option. If the price of the underlying asset slightly increases, the premium will raise the total return on the investment. In addition, if the price of the underlying asset slightly declines, the premium will offset the loss portion.

It is not recommended to use a covered call strategy if you expect a substantial appreciation of the underlying asset because your profits are locked to the strike price Strike Price The strike price is the price at which the holder of the option can exercise the option to buy or sell an underlying security, depending on of the call option. At the same time, if the price of the underlying asset significantly declines, the premium from the sale of the call will now cover only a small portion of the losses.

Example of a Covered Call

Here's a simple example of a covered call strategy. You've decided to purchase 100 shares of ABC Corp. for $100 per share. You believe that the stock market will not experience significant volatility Volatility Volatility is a measure of the rate of fluctuations in the price of a security over time. It indicates the level of risk associated with the price changes of a security. Investors and traders calculate the volatility of a security to assess past variations in the prices in the near future. You also predict that the share price of ABC Corp. will grow to $105 in the next six months.

In order to lock up your profits, you sell 1 call option contract with the strike price of $105 that will expire in six months (note that one call option contract consists of 100 shares). The premium on this call option is $3 per share in the contract.

Covered Call

Your future payoff depends on the price of the stock in six months. You face three scenarios:

Scenario 1: Stock price remains at $100 per share.

In such a scenario, the buyer will not exercise the call option because it is out-of-money (strike price exceeds the market price). Since the price will remain unchanged, you will not earn any return from the stock. However, you will earn $3 per share from the call premium.

Scenario 2: Stock price increases to $110.

If a stock price increases to $110 per share after six months, the buyer will exercise the call option. You will receive $105 per share (strike price of the option) and the $3 per share from the call premium. In this covered call scenario, you've sacrificed a small portion of potential profit in return for risk protection.

Scenario 3: Stock price decreases to $90.

In such a case, the call option will expire similarly to scenario 1. The stock will lose $10 per share in value, but the call premium of $3 per share will partially offset the loss. Thus, your final loss will be $7 per share.

More Resources

Thank you for reading CFI's explanation of a covered call. CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ Become a Certified Financial Modeling & Valuation Analyst (FMVA)® CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

Hedging Hedging Arrangement Hedging arrangement refers to an investment whose aim is to reduce the level of future risks in the event of an adverse price movement of an asset. Hedging provides a sort of insurance cover to protect against losses from an investment.
Options: Calls and Puts Options: Calls and Puts An option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an asset by a certain date at a specified price.
Spot Price Spot Price The spot price is the current market price of a security, currency, or commodity available to be bought/sold for immediate settlement. In other words, it is the price at which the sellers and buyers value an asset right now.
Technical Analysis: A Beginner's Guide Technical Analysis - A Beginner's Guide Technical analysis is a form of investment valuation that analyses past prices to predict future price action. Technical analysts believe that the collective actions of all the participants in the market accurately reflect all relevant information, and therefore, continually assign a fair market value to securities.