Covered Call
The Covered Call Strategy
The covered call is a great strategy for those stock investors who want to bring in some Premium (income) while holding onto their stock positions. Most commonly, the covered call strategy is implemented in a one short call per 100 stock shares ratio. Although selling the at-the-money (ATM) call brings individual investor the most premium, it also prevents any real gains if the stock were to move up sharply. This is why it is more common amongst traders to sell slightly out-of-the-money (OTM) calls against their stock position. This ensures more upside potential.
Note that the covered call risk profile is eerily similar to the short put risk profile.
Covered Call Risk Profile
Composition
Long the underlying security and short call options. Also known as a buy-write
Risk/Reward
Max Reward: Limited to premium received for call option sold.
Max Risk: Unlimited downside risk.
Generally used to generate cashflow when holding long term position on underlying asset.
Characteristics
A very common strategy among investors and fund managers who hold stocks and underlying assets for an extended period of time.
A Covered call or buy write is very effective when sideways moving markets and is considered more of a premium collection strategy with a slight bullish skew, rather than a down right bullish strategy.
This strategy is called a cover call because you sell a call on stock you already own, hence your call is “covered” (and not naked).
If you have been trading covered calls on an underlying you’ve owned and the underlying went down substantially, you would have dramatically reduced your loss because of the premium you collected over time. Trading covered calls is better than owning the “naked” stock in a down market because of this fact.
Important
A covered call is synthetically equivalent to a Synthetic Put. It is easy to see this by comparing risk profiles (image above).
Covered Call = Synthetic Put = Buy/Write
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