The covered call is a strategy in options trading whereby call options are written against a holding of the underlying security.
Long 100 Underlying, Sell 1 Call
Using the covered call option strategy, the investor gets to earn a premium writing calls while at the same time appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares.
However, the profit potential of covered call writing is limited as the investor had, in return for the premium, given up the chance to fully profit from a substantial rise in the price of the underlying asset.
Out-of-the-money Covered Call
This is a covered call strategy where the moderately bullish investor sells out-of-the-money calls against a holding of the underlying shares. The OTM covered call is a popular strategy as the investor gets to collect premium while being able to enjoy capital gains (albeit limited) if the underlying stock rallies.
Limited Profit Potential
In addition to the premium received for writing the call, the OTM covered call strategy's profit also includes a paper gain if the underlying stock price rises, up to the strike price of the call option sold.
Premium Received - Purchase Price of Underlying + Strike Price of Short Call - Commissions Paid
Profit achieved when: Price of Underlying >= Strike Price of Short Call
Unlimited Loss Potential
Potential losses for this strategy can be very large and occurs when the price of the underlying security falls. However, this risk is no different from that which the typical stockowner is exposed to. In fact, the covered call writer's loss is cushioned slightly by the premiums received for writing the calls.
Unlimited
Loss occurs when: Price of Underlying < Purchase Price of Underlying - Premium Received
Loss = Purchase Price of Underlying - Price of Underlying - Max Profit + Commissions Paid
Breakeven point
Purchase Price of Underlying - Premium Received
Example
An options trader purchases 100 shares of XYZ stock trading at $50 in June and writes a JUL 55 out-of-the-money call for $2. So he pays $5000 for the 100 shares of XYZ and receives $200 for writing the call option giving a total investment of $4800.
On expiration date, the stock had rallied to $57. Since the striking price of $55 for the call option is lower than the current trading price, the call is assigned and the writer sells the shares for a $500 profit. This brings his total profit to $700 after factoring in the $200 in premiums received for writing the call.
It is interesting to note that the buyer of the call option in this case has a net profit of zero even though the stock had gone up by 7 points.
However, what happens should the stock price had gone down 7 points to $43 instead? Let's take a look.
At $43, the call writer will incur a paper loss of $700 for holding the 100 shares of XYZ. However, his loss is offset by the $200 in premiums received so his total loss is $500. In comparison, the call buyer's loss is limited to the premiums paid which is $200.
Commissions
These examples exclude commissions and fees. Include all transaction costs when evaluating the profit or loss of a position.
Summary
Overall, writing out-of-the-money covered calls is an excellent strategy to use if you are mildly bullish toward the underlying stock as it allows you to earn a premium which also acts as a cushion should the stock price go down. So if you are planning to hold on to the shares anyway and have a target selling price in mind that is not too far off, you should write a covered call.
Similar strategies
Collars
As the covered call writer is exposed to substantial downside risk should the stock price of the underlying plunges, collars can be created to reduce this risk thru the use of put options.
In-the-money Covered Call Strategy
In-the-money covered call options are sold when the investor has a neutral to slightly bearish outlook towards the underlying security as their higher premiums provide greater downside protection.