Covered Calls

When people own stocks, they generally make money if share prices rise and lose money if share prices fall. But is there a way to earn additional income even when a stock's price barely moves? One investment strategy designed around this idea is called a covered call. To understand covered calls, we first need to understand options. An option is a financial contract that gives someone the right to buy or sell an asset at a predetermined price. A call option, in particular, gives its owner the right to buy an asset, such as a stock, at an agreed-upon price. Imagine that a company's stock is currently trading at $50 per share. Investor A owns 100 shares of this company. Since each share is worth $50, the total value of the investment is $5,000. Investor B, meanwhile, believes the stock's price could rise significantly. B wants the right to buy 100 shares for $55 each one month from now. To obtain this right, B is willing to pay Investor A a certain amount of money. Investor A agrees to sell B this right in exchange for $2 per share, or $200 in total. The $200 that A receives is called the option premium. Now, let's see what happens depending on the stock's price one month later. First, suppose the stock falls from $50 to $45. B has the right to buy shares for $55 each, but those same shares are available in the market for just $45. There is no reason to pay the higher price, so B lets the option expire without exercising it. A keeps all 100 shares and the $200 premium received earlier. However, the value of the shares has fallen from $5,000 to $4,500. That represents a $500 unrealized loss on the stock. After accounting for the $200 premium, the overall result is a $300 loss. What if the stock rises to $53 instead? B still has no reason to purchase shares for $55 when they are available in the market for $53. The option expires, and A keeps both the shares and the $200 premium. In this case, A has an unrealized gain of $300 on the stock and has received $200 from selling the option. Together, these amounts represent a $500 gain. Of course, the $300 increase in the stock's value is not a realized profit unless A actually sells the shares. Finally, suppose the stock climbs to $60. This time, things are different. B has the right to buy shares for $55 even though they are worth $60 in the market. If B exercises that right, A must sell the 100 shares at the agreed-upon price of $55 each. Since A originally held the shares at $50 each, selling them for $55 produces a $500 profit. Adding the $200 premium brings the total profit to $700. But what would have happened if A had never sold the call option? With the stock rising from $50 to $60, the value of the 100 shares would have increased by $1,000. By collecting the premium, A gave up some of the potential profit from a large increase in the stock's price. This is how a covered call works. An investor owns shares of a stock and sells a call option on those shares. The strategy is called "covered" because the investor already owns the shares that may have to be delivered if the option is exercised. In the U.S. stock market, a standard equity option contract generally represents 100 shares, although contract terms can vary. The main attraction of a covered call is that the investor can collect an option premium even if the stock's price does not rise significantly. When stock prices move sideways or increase moderately, this strategy can sometimes produce better results than simply holding the shares. However, option premiums are not free money. In exchange for receiving the premium, the investor gives up some of the potential gains if the stock's price rises sharply. The amount of the premium also depends on market conditions, expected price volatility, the time remaining until expiration, and other factors. It is not guaranteed to remain the same. More importantly, covered calls do not protect investors from major stock market losses. The premium can offset part of a decline, but the stock may still lose far more value than the premium provides. In our earlier example, if the stock falls to $20, the 100 shares lose $3,000 in value. Even after receiving the $200 premium, the investor still faces a $2,800 loss. These examples are simplified to illustrate the results at expiration and exclude trading fees, taxes, and dividends. In actual trading, an option may also be exercised before its expiration date, requiring the investor to sell the shares at the agreed-upon price. So how do ordinary investors use covered calls? Some investors buy stocks and sell options themselves. Others invest in exchange-traded funds, or ETFs, that use covered call strategies. Covered call ETFs invest in stocks or assets linked to stock indexes while using strategies that involve selling call options. These funds may use income from option premiums and other sources to make distributions to investors. Some pay distributions every month, which can make them attractive to people who want regular cash flow from their investments. However, a large distribution does not necessarily mean an investment is performing well. ETF distributions can come from several sources, including option premiums, dividends, and returns of capital. Paying a distribution can also reduce the fund's net asset value. If the value of the fund's investments declines, investors may lose money overall despite receiving regular payments. That is why investors should consider an ETF's total return, which includes both changes in its share price and the distributions it pays, rather than focusing only on the size of its distributions. During a prolonged period of strong stock market growth, a covered call ETF may underperform a traditional stock ETF because some of its potential gains are limited. Ultimately, a covered call is an investment strategy that exchanges some potential stock price appreciation for option premium income. It can work well when prices remain relatively stable or rise gradually. However, profits can be limited when prices surge, while substantial losses are still possible when prices fall sharply. Successful investing is not just about how much money you receive regularly. It is also about understanding the opportunities you give up and the risks you accept in exchange for that money. Covered calls demonstrate an important investment principle: Income that appears consistent or attractive often comes with trade-offs that investors need to understand.