Covered call operation principles and insights.

This is a free tutorial article, hope it helps you.

Generally, I don't trade options in my public portfolio, but occasionally I do covered calls. I know many fellow investors don't understand what options are, let alone covered calls. Therefore, I decided to write a tutorial article to make it easier to understand (some parts were assisted by AI).

What is a Covered Call?

A Covered Call is an investment strategy that combines stocks and options, belonging to a conservative income-enhancing strategy. Investors sell call options on a stock they already own (i.e., hold a long position in the stock) to earn premiums. This strategy is suitable when the stock price is expected to remain flat or rise slightly, using the premium to reduce the cost of holding the stock and increase returns.

The term "Covered" in Covered Call refers to the fact that the investor holds the underlying stock matching the number of call options sold. Even if the options are exercised, the investor has enough shares to deliver without needing additional funds.

How Covered Call Works

Hold the stock & sell call options:

I'll use my holding of SOFI as an example. Suppose I hold 10,000 shares of SOFI. In the U.S. market, 1 option contract represents 100 shares. So, I sold 100 contracts (corresponding to 10,000 shares of SOFI) of call options expiring this Friday with a strike price of $17.5. I sold them at approximately $0.19, which is the premium.

Profit:

The profit I earn will be 0.19X100X100=$1,900. Here, 0.19 is the premium, the first 100 is the number of option contracts, and the second 100 represents the number of shares per contract (fixed at 100 in the U.S. market). Thus, the profit from a covered call is fixed, essentially the price at which you sold the options, assuming you hold until expiration without any intermediate trades.

Role of Premium:

Regardless of how the stock price moves, the investor keeps the premium as part of the profit. This premium can be used to reduce the cost of holding the stock or as additional cash flow.

Expiration Scenarios:

Stock price below the strike price:

If the stock price is below the strike price at expiration, the option will not be exercised, and the investor keeps both the stock and the premium.

Stock price above the strike price:

If the stock price is above the strike price, the option will be exercised, and the investor must sell the stock at the strike price to the buyer but still keeps the premium.

In the U.S. market, options can be exercised before expiration, not just on the expiration date, so this is something to keep in mind.

Risks and Limitations of Covered Calls

Although Covered Calls are a relatively conservative strategy, there are still some risks and limitations that investors should fully understand before implementing the strategy.

1. Limited Upside Potential

Covered Calls cap the investor's maximum profit because if the stock price exceeds the strike price, the investor is forced to sell the stock at the strike price and cannot benefit from further price increases. For example, using SOFI as an example, if the price rises above $17.5 this week, any further gains are irrelevant to you. Thus, you can view a covered call as setting a take-profit level.

2. Downside Risk

Covered Calls do not protect investors from stock price declines. If the stock price falls, the investor still faces losses on the stock, with the premium only partially offsetting the loss. For example, if SOFI drops from $17 to $15.5, your loss remains unchanged, except for the additional premium earned.

3. Contract Quantity Limitations

Option contracts are traded in units of 100 shares, so investors must hold at least 100 shares to sell one Covered Call. If an investor holds fewer than 100 shares, this strategy cannot be used.

4. Early Exercise Risk

In some cases (e.g., when the stock is about to pay dividends or the option is near expiration), the buyer may exercise the option early, forcing the investor to sell the stock prematurely and potentially miss out on future gains.

5. Liquidity Issues

If the sold options have low liquidity, the premium quotes may not be favorable, resulting in insufficient compensation for the investor.

6. Tax Implications

In the U.S., the tax treatment of Covered Calls can affect investor returns. For example, if the stock is exercised, capital gains tax may apply. Additionally, premium income may be treated as short-term gains, subject to higher tax rates.

When to Use Covered Calls?

Covered Calls are suitable in the following scenarios:

Stock expected to trade flat or rise slightly:

If the investor believes the stock price will not fluctuate significantly, Covered Calls can be used to earn premiums and increase cash flow.

Reducing holding costs:

Investors who want to hold stocks long-term can sell options to reduce holding costs, using the premium as supplemental income.

Need for stable income:

Investors seeking stable income can use Covered Calls as an income-enhancing tool, especially during periods of low market volatility.

Advantages of Covered Calls

Stable cash flow:

Selling call options provides investors with steady cash income, particularly when stock prices are stable.

Reduced holding risk:

Premiums can partially offset losses from stock price declines, lowering overall risk.

High flexibility:

Investors can adjust strike prices and expiration dates based on market conditions to match their risk tolerance and profit goals.

Disadvantages of Covered Calls

Profit cap:

Once the stock price exceeds the strike price, investors cannot participate in further gains.

Not suitable for highly volatile stocks:

Highly volatile stocks may experience significant price swings, making Covered Calls ineffective for capturing upside or fully hedging downside.

Need to monitor expiration dates:

Investors must keep track of option expiration dates and market changes to avoid missing potential profits due to oversight.

Personal Experience

I believe the benefits of Covered Calls are clear. I want to share some negative experiences from my own practice.

1. After selling Covered Calls, the stock price suddenly surges. Stocks always have good or bad news. I once sold Covered Calls, and the stock suddenly surged due to good news. I judged that the price could rise further, so I had to buy back the call options at a higher price, which reduced my overall profit.

2. The stock suddenly surges, but you hesitate to sell. Sometimes, the stock price spikes quickly. As a trader, you might think it will drop soon, but because you sold Covered Calls, you don't dare to sell the stock, as it would turn into a naked short call, which is very risky! So, you end up doing nothing. Later, the stock price does drop, and you miss a good trading opportunity because the call options restricted your actions.

Conclusion

In short, selling Covered Calls is like setting a take-profit level at a certain price. The advantage is increasing returns and reducing holding costs. However, Covered Calls also come with many limitations. For example, when the stock price suddenly surges, you might want to sell, but because of the Covered Calls, you end up not acting (selling the stock would turn it into a naked short call, which is very risky!). This could also reduce your overall profit.

Thus, Covered Calls are not a perfect strategy but just one way to enhance returns. They work best when used at the right time.

Finally, if you have any questions, feel free to leave a comment. If you found this article helpful, please Like, Comment & Share. Thank you!

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