How to use a covered call options strategy

What’s on this page?

1. What is a covered call?
2. Covered call options strategy explained
3. Covered call example
4. How the Greeks affect covered calls
5. What to keep in mind before you write a covered call

What is a covered call?

A covered call is an options trading strategy that involves selling (or writing) a call option on an asset that you already own. Here are the two parts of a covered call options strategy:

1. Owning shares of a stock or an exchange-traded fund (ETF)

2. Selling call options on that same stock or ETF. If the shares you own are in a stock, you’d sell an equity call option; if they’re in an ETF, you’d sell an ETF call option. Each standard equity or ETF options contract represents 100 shares of the underlying asset, so you’d sell one call for every 100 shares you own

In the second part of the strategy, you’d sell a call option. This call gives your counterparty in the options contract (the buyer) the right to buy your long shares at a set price (the strike price) by a certain date (the expiry date). In exchange for this right, the buyer will pay an upfront fee. This fee is known as the premium and will be paid to you as the call writer.

If the stock or ETF price:

• Stays below the strike price, the option will likely expire worthless, in which case you’d keep the premium as profit. You’d also keep your shares. Although unlikely, a short call option can be assigned even if the stock or ETF price is below the strike price (ie the option is out of the money, or OTM for short)*

• Rises above the strike price, the call buyer will likely exercise their right to purchase your shares at the strike price. In this case, you’d keep the premium, but you’d have to sell your shares at the strike price, even if their market price was higher

Using covered calls with us

With us, you can employ this strategy on our US options and futures platform. There are different ways to acquire the shares you need for this strategy using a US options and futures account. They are:

1. Physical delivery, which occurs when you exercise an in-the-money (ITM) equity or ETF options contract or let it expire, and you have enough funds available in your account to cover the acquisition. You can acquire shares through physical delivery when you’re a call option holder

2. Assignment, which refers to fulfilling your obligation to buy (as a put option writer) or sell (as a call option writer) the underlying asset when the contract holder exercises their right to sell or buy, respectively. You can acquire shares through assignment when you’re a put seller

3. Direct purchase via our US options and futures platform

4. Transfer of shares from a share dealing account to a US options and futures account, provided the shares in question are listed in the US

Covered call options strategy explained

The buyer of a call will typically exercise their right to buy if the underlying asset’s price exceeds the strike price on or before the expiry date. If the underlying asset’s price doesn’t increase to this point, the buyer will likely not exercise their option because the underlying asset would cost less in the open market.

Selling a call against your long position (ie the shares you own) limits the upside potential of that position. The maximum profit that a covered call can make is calculated as follows:

(the call option’s strike price – the purchase price of the underlying stock or ETF) + the premium received for writing the call

However, a covered call does limit your downside potential, too. The maximum loss is calculated as follows:

the purchase price of the underlying stock or ETF – the premium received for writing the call

How and when to sell a covered call

Covered calls are primarily used for two reasons:

To offset losses on your existing long position

You’d generally use a covered call if you had a bullish outlook and wanted to hedge against potential losses on an existing long position. If you were incorrect in your bullish assumption and the underlying asset fell in value, the short call would offset some of the losses that your investment position would incur. You could sell your holding and still have earned the option premium from the call.

To make money when the market is less active

A covered call is a neutral strategy, which means that it can be used when little movement is expected in the underlying market. So, if you were fundamentally bullish but believed that the underlying asset’s price would only rise steadily or not surpass a certain point by the expiry date, then you could sell a call option with a strike price beyond that point.

However, you’d only do this if you thought the call buyer was unlikely to exercise the option if the asset’s price didn’t move beyond the strike price by the expiry date.

If both the market and the buyer behaved as you anticipated, the option would expire worthless and you’d keep the premium you received as profit. You’d also keep the shares that you own.

Covered call example

Suppose you own 100 shares in company ABC, which you bought for $40 per share ($4,000 in total). You believe that the shares have a strong chance of generating a profit in the long term, but your short-term expectation is that the share price will either fall or rise modestly from its current level of $50.

As a result, you decide to employ the covered call strategy, selling a call option (with a strike price of $60) on your ABC shares. Let’s assume that the premium for this call option is $1 per share. So, for your 100 shares, you’d receive a total premium of $100.

If ABC’s share price rises above $60, the option will be in the money and will either be exercised or allowed to expire. You’d then have to sell your shares at the strike price. In doing so, you’d make a $20 profit per share (the difference between the strike price and the initial purchase price).

Your total profit on the covered call would be $2,100 (the $100 premium, plus $20 profit for each of your 100 shares). This would be the maximum possible profit you could make.

If ABC’s share price rises but remains below the strike price, the option will be out of the money and will likely expire worthless. In this scenario, you’d still make a profit on the covered call, but it would be limited to the amount of the premium you received, ie $100. You would, however, get to keep your shares in ABC.

How the Greeks affect covered calls

The Greeks can help you estimate the likely changes in an option’s value based on different factors that can impact it throughout its lifespan. In turn, this can help you manage your risk when trading options. You can use the Greeks as a built-in feature on our US options and futures platform. The four prominent Greeks are delta (∆), gamma (Γ), theta (θ) and vega (V).

Delta

Delta is how much an option’s price moves for every point of movement in the underlying asset’s price. For example, if a call option had a delta of 0.5, its value would increase by 0.5 for every point of movement in the underlying asset’s price.

• When buying a call: a higher delta would be preferable, as that would mean the underlying’s price would likely move toward (and past) the strike price much faster, which would see the option gain intrinsic value

• When selling a call: a lower delta would be preferable, as the underlying asset’s price movements would then have a lower impact on the option’s price

Theta

Theta, also known as time decay, is a measure of how much an option’s value declines over time. An OTM option with high theta will rapidly depreciate in value as it nears its expiration date, as it would have less chances of having intrinsic value by the time of expiry.

For call sellers, the remaining profit potential for an OTM option will be higher the closer the option gets to expiry. This is the general rule, but it would also depend on other factors such as volatility and the distance between the option’s price and its strike price.

However, if the option is ITM with less time remaining until expiry, it’ll be less likely to expire without value, lessening the chances of earning a profit from selling a call.

Theta and delta shown using table mode in the trade tab of our US options and futures platform:

Vega

Vega measures the sensitivity of an option to changes in implied volatility (IV). For example, if an option has a vega of 1, its price will move by one point for every 1% change in the IV of the underlying market.

Vega is highest when an option is at the money (ATM) but will decline when the underlying asset’s market price moves away from the strike price in either direction.

For a call seller, it’s preferable if implied volatility remains low, as that would mean that the underlying’s price is unlikely to hit the strike price. But if IV rises, the underlying’s price is more likely to rise to the strike price.

Gamma

Gamma provides an indication of how much an option’s delta might change over time based on movement in the underlying asset’s price. Delta moves as the price of the underlying asset shifts – this is where gamma comes in. Gamma measures the expected change in an option’s delta for each $1 change (up or down) in the underlying asset’s price.

Vega and gamma shown using table mode in the trade tab of our US options and futures platform:

Important factors to consider before writing a covered call

• A covered call is an options trading strategy that involves selling a call option on an asset that you already own

• Your counterparty in the options contract (ie the call holder) will have the right to buy your long shares at a set price by a certain date. In exchange for this right, the holder will make an upfront payment to you that’s known as the premium

• Covered calls are typically used in neutral and slightly bullish markets with the aim of generating profit

• The strategy enables you to hedge against the risk of potential losses on an asset that you own

• The maximum possible profit is the difference between the price you originally paid for your shares and the strike price of the call, plus the premium you received

• The maximum possible loss is the initial purchase price of the shares minus the premium received for selling the call

• If the underlying asset’s price increases beyond the strike price, the option will be in the money. If the contract then expires or is exercised by the call buyer, you’d have to sell your shares

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