When a seller engages in a covered call, they sell purchasers call options on securities that the seller already owns at a predetermined strike price and time to expiration. Trading professionals use covered calls as a tool to increase their portfolio's return. Covered call options are a cautious but effective strategy that can also be used by individual investors who take the time to study how they work and when they are appropriate to utilize.

Keep reading to see how a covered call can boost your income, reduce your portfolio's risk, and increase your investment results.

What Is a Covered Call?

As a stock or futures contract holder, you have a number of privileges, including the ability to liquidate your holdings at any moment for market value. Covered call writing offers this right to someone else in exchange for cash, meaning the buyer of the option obtains the right to purchase your security on or before the expiration date at a predetermined price called the striking price.

A call option offers the buyer the right, but not the duty, to purchase the underlying stock or futures contract at the strike price at any point before the option's expiration. The seller of a call option is said to be "covered" if he or she also holds the underlying securities, which means that the option can be exercised without the seller having to buy the instrument at market price.

Earning Money with Covered Calls

To acquire the right to purchase shares or contracts at a set future price, the buyer of a call option pays a premium to the seller of the option (the strike price). Whether or not the option is ultimately exercised, the premium paid on the day it is sold belongs to the seller.

Therefore, if the stock rises over the strike price, resulting in a profit from the long stock position, then the covered call strategy is the most profitable. If the buyer of a covered call does not anticipate the underlying stock price increasing and does not exercise before the option's expiration, the writer of the call will keep the entire premium received for selling the option.

If the buyer of a covered call exercises their option, the seller of the call will sell the underlying shares at the strike price and pocket the premium. But by selling at the strike price, the seller forfeits any future gains in value due to an increase in the share price.

In what circumstances should one sell a covered call?

The tradeoff for receiving payment while selling a covered call is future appreciation. Let's say you invest $50 in XYZ stock with the expectation that its price will increase by 20% to $60 in a year. Plus, you're ready to cash out at $55 within the next six months, forgoing potential growth in exchange for a quick buck. In this case, it could be beneficial to sell a covered call on the position.

According to the stock's option chain, the premium on the sale of a $55 call option with a six-month expiration date is currently $4 per share. If you bought shares at $50 each and thought they may be worth $60 a year from now, you could sell that option. If the underlying price rises to $55 within the six-month period after the covered call is written, the investor will be obligated to sell their shares. If you sell 100 shares for $55, you'll get $59. This represents an 18% return in six months, and you get to keep the $4 premium as well.

In contrast, if the stock drops to $40, you'll lose $10 on the original position since the buyer won't exercise the option because they can buy the shares for less than the contract price. The loss per share is reduced from $10 to $6, however, because you get to keep the $4 premium from the call option transaction.

Covered calls have a number of benefits.

By accepting the premium in exchange for potential appreciation over and above the strike price + premium throughout the contract period, selling covered call options can help mitigate downside risk or increase upside gain. In other words, the seller makes less money than they would have if they had just kept the XYZ stock and let it rise to a closing price of $59. If the stock price drops throughout the six-month period and closes at less than $59 a share, the seller will either profit or incur a smaller loss than if the options sale had not occurred.

Issues Associated with Covered Calls

Call sellers who don't hold underlying shares or contracts are said to be "naked call holders," who are exposed to potentially infinite losses in the event that the underlying security increases in price. In order to sell shares or contracts, sellers must first purchase back options holdings prior to expiration, which raises transaction costs while decreasing or boosting net gains or losses, respectively.

Final Note

Covered calls can be a low-risk strategy for option holders to produce income, and they are particularly popular among retirees who don't want to sell their positions but could use some extra cash flow. A covered call allows you to make a small return while exposing yourself to minimal risk.