What is a Covered Call?

//What is a Covered Call?
What is a Covered Call? 2017-10-02T07:51:28+00:00

Definition: A covered call is a strategy in which investors write call options against shares they already own. Each covered call represents 100 shares and the option seller collects an option premium for selling a covered call to an option buyer.

What Does Covered Call Mean?

Writing a covered call generates extra income immediately. The investor who writes the covered call expects the share price to stay flat or below the strike price on maturity. In that way, the option buyer will not exercise the option, thereby leaving the option seller with the shares and the option premium. Normally, covered calls are employed by investors with a short-term horizon and a long position in the underlying stock.

Let’s look at an example.

Example

Kellogg currently trades at $80 per share. Alex sells Jonathan a call option at a strike price of $90 and maturity in May. The call option per share is $2 for every 100 shares, so Alex receives an option premium of $200 for this call option. Alex believes that Kellogg will reach $95. So, in fact, he sells the call option to Jonathan today for $90, expecting that until maturity the stock will remain under $90.

If Kellogg trades at $80 on maturity, then Jonathan loses $200 and Alex makes $200.

If Kellogg trades at $95 on maturity, then:

Jonathan earns 100 shares x $90 per share = $9,000 and can sell them for 100 shares x $95 per share = $9,500, so he realizes a total gain of $500 – $200 = $300.

Alex earns $15 x 100 shares = $1,500 because the stock went from $80 to $95. Yet, he owes Jonathan 100 shares for $90 each. So, Alex loses ($95-$90) x 100 = $500. Ultimately, Alex’s net earnings are $1,500 – $500 + $200 premium = $1,200.

Because Alex has written a covered call to Jonathan, he actually put an upside protection to his trade and received $200 as an option premium. So, in fact, Alex’s $1,500 gain is split between himself ($1,200) and Jonathan ($300).