Covered call definition

What is a covered call?

A covered call is a call option trading strategy. It involves holding an existing long position on a tradeable asset, and writing (selling) a call option against the same asset, with the aim of increasing the overall profit that a trader will receive.

Why do traders use covered calls?

A covered call is employed by traders who are fundamentally bullish but believe the underlying asset will rise steadily, or not beyond a certain price point. Under these circumstances the trader is able to make a profit from both the long position and the short call position.

This enables the trader to secure a greater return than would be possible from holding the long position alone. If their bullish view is incorrect, the short call serves as a hedge to offset some of the trader’s losses that are incurred as a result of the asset falling in value.

How do covered calls work?

Covered calls work because a trader who currently holds a long position on an asset gives up their right to sell that asset at any time for the market value. Instead, under the obligations of a call option, they must sell the asset to the buyer at the expiry date for the strike price – so long as the buyer exercises their right to buy.

From the call seller’s perspective, they would only be worried if the underlying asset price rises to levels greater than the strike, at which point the buyer can be expected to exercise the option. However, if the sellers are already long on the underlying instrument, they would already be profiting from the upward move.

Buyers of calls will typically exercise their right to buy if the underlying price exceeds a pre-determined strike price at or before a given expiry date. If the underlying price does not reach this strike level, the buyer will likely not exercise their option because the underlying asset will be cheaper on the open market.

Covered call example

Let’s suppose a trader owns 100 shares in company ABC, which they think have a strong chance of generating profit in the long term. But in the short term they expect the share price to fall – or to not increase dramatically – from the current price of £50.

As a result, the trader decides to sell a call option on the same stock with a strike price of £60. They will earn a premium by selling this call option, but they will cap the total upside potential of their share investment at £60 – or a £10 profit per share.

In this example, let’s assume that the premium for this call option is 100p per share. Since options are always traded in lots of 100 shares, the trader stands to receive a total premium of £100.

The trader will generate a profit for all gains up to a share price of £60, after which any additional profits will be offset by losses incurred on the short call option. This is because it is now above the stated strike, meaning the option is 'in-the-money'.

As a result, the maximum the trader stands to gain is the £100 premium, plus £10 profit per share. So, their total profit is capped at £1100 (for an underlying share price of £60 or greater) because they own 100 shares.

Now, if the share price rises to levels greater than £60, the trader will not realise these additional gains – or to be more accurate, gains in the long ABC position have been offset by losses on the short call.

However, for lesser upward movements – or drops in share price – the premium obtained by selling the call serves as a useful source of revenue, either to increase profits or to mitigate losses.