Covered Call

A covered call is an options strategy in which an investor who owns an asset, usually shares, sells a call option on the same asset. The investor receives the option premium at once. In return, the buyer of the call gains the right to purchase the shares at the strike price, so the investor's profit is capped if the price rises above that level. The call is covered because the shares needed to meet the obligation are already held.

The strategy is also known as a buy-write when the shares are bought and the call is sold at the same time. It is one of the most common uses of options among individual investors and is the basis of a class of income-oriented funds. It is often described as generating income, though the premium is better understood as payment for giving up part of the potential gain.

For a position opened by buying shares at $S_0$ and selling a call with strike $K$ for a premium $P$, the figures per share at expiry are:

• $S_0$ is the purchase price of the shares.
• $K$ is the strike price of the call sold.
• $P$ is the option premium received.

The maximum loss occurs only if the share price falls to zero. An investor buys 100 shares at $100 and sells one call with a $105 strike for $2.50 a share. The maximum profit is (105 − 100) + 2.50 = $7.50 a share, earned if the shares finish at or above $105. The break-even price is 100 − 2.50 = $97.50.

If the shares finish at $90, the call expires worthless and the position has lost 10 − 2.50 = $7.50 a share, against $10 for the shares alone. If they finish at $120, the shares are called away at $105 and the profit is $7.50, against $20 for the shares alone. The premium softens a fall by a fixed amount and removes most of a large rise.

The seller chooses how much upside to give up. An out-of-the-money call, with a strike above the current price, brings a smaller premium and leaves room for some gain. A call struck at or below the current price brings a larger premium and more protection but caps the position at once. Short-dated calls lose value fastest, which is why many covered call programs sell options with about one month to expiry and repeat the sale each month.

Premiums are larger when implied volatility is high. High implied volatility reflects a market view that large moves are more likely, so the larger premium comes with a greater chance that the shares fall sharply or rise through the strike.

By put-call parity, owning the shares and selling a call has the same payoff at expiry as selling a put option at the same strike while holding the strike amount in cash. Both positions earn a limited premium if the price stays up and bear nearly the full loss if it falls. The covered call is thus a way of selling volatility. It is not the conservative opposite of a naked option sale that its name may suggest.

The Cboe S&P 500 BuyWrite Index, known by its ticker BXM, tracks a strategy of holding the S&P 500 and selling a one-month index call each month. Studies of the index found that over long periods the strategy earned returns close to those of the index with noticeably lower volatility. One explanation is the volatility risk premium: index options have on average been priced at an implied volatility above the volatility later realized, so sellers were paid somewhat more than the fair cost of the risk.

The result depends on the period. In strong and sustained bull markets, buy-write strategies have lagged the index by a wide margin because gains above the strike were given up month after month. In sharp declines they have fallen almost as far as the index. A number of exchange-traded funds now run the strategy and pay out the premiums as distributions. Those payouts are not the same as a fund's total return, which can be much lower when the underlying shares have fallen.

• Downside exposure. The position keeps almost all the risk of owning the shares. The premium offsets only a small fall.
• Capped upside. After a large rise the shares are sold at the strike, and an investor who wants to stay invested must buy back at the higher price.
• Early assignment. An American option can be exercised at any time. Calls that are in the money are often assigned just before the ex-dividend date, in which case the seller delivers the shares and does not receive the dividend.
• Tax and costs. Having shares called away is a sale and may trigger capital gains tax. Frequent option sales add commissions and bid-ask costs.

A covered call suits a view that the price will be flat or rise modestly. It gives no protection against a severe fall, and the regular premium should not be mistaken for a return that is free of risk.

• Cboe Global Markets
• The Options Clearing Corporation