A covered call is an options strategy where you buy a stock or ETF, and write (sell) call options on the same stock or ETF. Writing covered calls is a way to generate income for investors who have a short term neutral view on the stock or ETF.
The risk of writing a covered call is the loss of the underlying shares if the seller (writer) of the call is assigned an exercise notice. If assignment occurs or the strike price is in-the-money at expiration, then the writer is obligated to sell the shares of the underlying stock at the option contract's strike price. Keep in mind, the seller of the call receives the proceeds of the sale (minus any assignment charges).
When writing a call, typically an investor will need at least 100 shares of the stock or ETF for each call option that is written.
For example, let's say that you own shares of the TSJ Sports Conglomerate and like its long-term prospects as well as its share price but feel in the shorter term the stock will likely trade relatively flat, perhaps within a few dollars of its current price of, say, $25. If you sell a call option on TSJ for $26.00, you earn the premium from the option sale, minus trade costs, but cap your upside.
One of three scenarios is likely to play out:
- TSJ shares trade flat (below the $26 strike price) – the option will expire worthless and you keep the premium from the option, minus trade costs. In this case, by using the covered call strategy you have successfully outperformed the stock.
- TSJ shares fall – the option expires worthless, you keep the premium, and again you outperform the stock.
- TSJ shares rise above $26 – the option is exercised, and your upside is capped at $26, plus the option premium. In this case, if the stock price goes higher than $26, plus the premium, your covered call strategy has underperformed the TSJ shares.
Find out more details about the covered call options strategy and applicable risk.
Please note: Options involve risk and are not suitable for all investors. Before investing in options, please read the Characteristics and Risks of Standardized Options.