When employed correctly, covered calls and covered puts can help manage risk by potentially increasing profits and reducing losses simultaneously. Let’s discuss how.
What is a covered call?
A covered call is when you sell someone else the right to purchase a stock that you already own (hence “covered”), at a specified price (strike price), by a certain date (expiration date). When it’s structured properly, both time and price can work in your favor.
Covered calls are one of the most common and popular option strategies and can be a great way to generate income in a flat or mildly uptrending market. They also offer limited risk protection—confined by the amount of premium received—that can sometimes be enough to offset modest price swings in the underlying equity.
If you own stock that has declined sharply in price since the purchase date, covered calls are probably not the best choice for trying to recover some of your losses. It’s also important to note that a covered call writer (seller) relinquishes any profitability above the strike price.
When do you use a covered call?
Investors typically write covered calls when they have a neutral to slightly bullish sentiment. In many cases, the best time to sell covered calls is either at the time a long equity position is established (buy/write), or once the equity position has already begun to move in your favor.
When establishing a covered call position, most investors sell options with a strike price that is at-the-money (ATM) or slightly out-of-the-money (OTM). If you select OTM covered calls and the stock remains flat or declines in value, the options should eventually expire worthless, and you'll get to keep the premium you received when they were sold without further obligation. If you select ATM covered calls and the stock declines in value, they too should expire worthless and the outcome is essentially the same.
If the stock appreciates in value above the strike price, you'll probably have your stock called away (assigned) at the strike price, either prior to or at expiration. This may be a good thing. If you sold ATM or OTM calls, the trade will generally be profitable. Unless your options are deep in-the-money (ITM), that profit will usually exceed the one you would have earned if you had bought the stock outright and sold it at the appreciated price. It is also the maximum profit that can be earned on a covered call trade.
A covered call example
Here's a hypothetical example of a covered call trade. Let's assume you:
- Buy 1,000 shares of XYZ stock @ 72
- Sell 10 XYZ Apr 75 calls @ 2
Because you bring in two points for the covered call, it provides two points of immediate downside protection. In other words, you will not have a loss unless the stock drops below $70.
But there's always a downside, and in this example the trade-off is that you limit the upside profit potential beyond a price of $77. So you would only want to do this if you think the price of XYZ will not exceed $77 by the April expiration. If XYZ does increase above $77, the stock purchase alone would have been more profitable.
Look at the profit and loss chart below. Notice that:
- The breakeven price is $70.
- The profit is capped at $5,000 for all prices above $75, i.e.: $3 x 1,000 [shares stock] + $2 x 10 [options contracts] x 100 [options multiplier]
- The stock can drop two points before you go into the red. Losses will be incurred below $70 to zero.
- Losses could be as much as $70,000 if the stock price drops to zero, but they will always be $2,000 less than the stock trade alone.
Note: Chart depicts strategy at expiration.
What is a covered put?
Covered puts work essentially the same way as covered calls, except that the underlying equity position is a short instead of a long stock position, and the option sold is a put rather than a call.
A covered put investor typically has a neutral to slightly bearish sentiment. Selling covered puts against a short equity position creates an obligation to buy the stock back at the strike price of the put option.
Just like with covered calls, the best time to sell covered puts can be either at the same time a short equity position is established (called a sell/write), or once the short equity position has already begun to move in your favor.
A covered put example
Here's a hypothetical example of a covered put trade. Let's assume you:
- Sell short 1000 shares of XYZ @ 72
- Sell 10 XYZ Apr 70 puts @ 2
Take a look at the profit and loss chart below. Notice that:
- The breakeven price is $74.
- The profit is capped at $4,000 for all prices below 70, i.e.: $2 x 1,000 [shares stock] + $2 x 10 [options contracts] x 100 [options multiplier]
- Even though there are two points of price protection against an increase in the stock price, losses will be incurred above $74.
- Losses could be unlimited if the stock price continues to increase, but they will always be $2,000 less than the stock trade alone.
You would want to employ this strategy only if you think the price of XYZ will not fall below $70 by the April expiration. If XYZ does fall below $70, the short stock trade alone would be more profitable.
Note: Chart depicts strategy at expiration.
Risk managed, not eliminated
While covered calls and covered puts reduce risk somewhat, they cannot eliminate it entirely. With that in mind, here are a few cautionary points about these strategies:
- Profits. Covered options usually prevent significant profit potential if a stock moves substantially in your favor. Anytime you sell a covered option, you have established a minimum buying price (covered put) or maximum selling price (covered call) for your stock. Any stock movement beyond that established price creates no additional profit for you.
- Losses. Losses are reduced only by the amount of premium you received on the initial sale of the option. In addition, it’s rarely a good idea to sell a covered option if your stock position has already moved significantly against you. Doing so could cause you to establish a closing price that ensures a loss. So before you sell, ask yourself, "Would I be happy if I had to close out my stock position at the strike price on this option?" If you can answer "yes," you’ll probably be okay.
- Holding until expiration. While our examples assume that you hold the covered position until expiration, you can usually close out a covered option at any time by buying it to close at the current market price. Regardless of whether the equity part of your strategy is profitable or not, waiting until expiration will maximize your return on an out-of-the-money option; however, you are not required to do so.
- Assignment. A significant change in the price of the underlying stock prior to expiration could result in an early assignment, and if your short option is in-the-money, you could be assigned at any time. Covered calls written against dividend paying stocks are especially vulnerable to early assignment.
- Corporate events. When companies merge, spin off, split, pay special dividends, etc., their options can become very complicated. Schwab clients should visit the StreetSmart Edge® trading platform for detailed information on adjusted options and their new terms; please review it carefully before you trade them.