Covered Call Position

The Covered Call Writing setup is created when you sell (“write” or “short”) a call against an established position or a new position in the underlying stock. This position creates a net credit. It is an opportunity for you to create additional income as a result of the premium you receive and increase the overall return on the stock. It also provides you with some downside protection in the event that the price of the stock falls.

Setup Mechanics Description:

You establish a covered call write setup against a position in a stock you already own or you can enter a new stock position at the time of writing the call.

Covered calls setups work best in a neutral market or if you have a slight-to-moderate bullish outlook. The position takes advantage of a neutral or potentially bullish market, where the time decay of the short call will cause it to expire worthless.

Covered call writing looks to profit when the outlook on a stock isn’t particularly bullish.  It is considered one of the safest option setup and one of the earliest trading permissions that that broker would give when a trader is looking to get started with options.

The increased returns in a slightly bullish to neutral environment come with a trade-off.  You must be willing to sell the stock at the strike price even if the stock continues to appreciate in a strong bull market. Should an exercise take place before the expiration of the short call, you will need to sell your stock at the strike price. The strike price (higher than the original purchase price of the stock) establishes the sale price of the stock, locking in its future value for the person who holds the call option you sold.

You will break-even in this position when reaching the stock’s original purchase price less the premium received, should the price of the stock fall. You want the short call to expire worthless, keeping the premium as additional income, and maintaining your position in the stock in the event it becomes bullish.

You want slight appreciate or no movement in the price of the stock, allowing time decay slowly erode away all premium in the short call.  When this happens, you will profit from the premium received.  If you sold the call slightly above the current price of the stock, you will also profit from the increased value of the stock.

Your maximum potential profit for the position is the difference between the stock’s original purchase price (the amount originally paid for the stock) and the strike price of the short call, plus the premium received.

Exercise of the short call may be seen as a success for you as you will keep the premium and profit from the increased price when selling the stock. However, if the stock price rises well above the strike price of the call that you sold, then you will sacrifice the additional gains to the trader who holds the call.

Your maximum potential loss for the position is the stock’s original purchase price less the premium that you will receive at trade entry.  Note that this assumes that the stock goes to $0/share.  This, of course, is improbable and it’s important to note that you will lose less money with the covered call position than if you held the stock outright.

The broker will debit your account by the amount required to purchase the stock and credit your account for the call that you sold. Since this is your maximum risk exposure for the setup, no additional margin will be required.

Time decay is your ally in this position. Selling a call against a stock that you own exposes you to the risk of having to deliver the stock at a price that will be lower than the market price of the stock in a rising market. This happens as the call goes in the money and continues to increase in value. If the market remains neutral or slightly bullish, then you will benefit from time decay in the short call.

An increase in implied volatility is not desired for covered call writing. An increase in volatility has the potential to make the cost of the call more expensive, eliminating the chance for you to buy it back to close out the short position at a price desirable to maintain profitability. You will want volatility to remain low or decrease throughout the position.

The covered call writing setup helps you take short-term profits from your established stock position or a newly established position; this is a great benefit for employing this strategy. An increase in implied volatility is undesirable as it causes price changes to go against writing the call, and subjects you to a possible exercise prior to expiration should the call go in the money. It is best utilized in a market that is neutral or slightly bullish with time decay as a benefit.

Key advantages include:

1. Increases the overall return on the underlying stock you hold based on the value of the premium received plus the value of the stock as the market price increases.

2. Provides you with some downside protection against a decline in the stock price, which is the value of the premium received (less the stock’s original purchase price).

3. It is deemed to be a safe position (safer than holding the stock outright) since you own the stock for which the call is sold against; the only true loss (in comparison to holding the stock without the call) is the ‘opportunity cost’ should the exercise occur and delivery takes place as the price of the stock continues to rise in a bullish market.