Covered Call

A Covered Call (also known as a 'buy-write') is a popular and surprisingly conservative investment strategy. Think of it as renting out the stocks you already own. The strategy involves two parts: first, owning at least 100 shares of a stock, and second, selling a call option against those shares. By selling this option, you are giving someone else the right (but not the obligation) to buy your shares from you at a predetermined price—the strike price—on or before a specific date—the expiration date. In return for selling this right, you receive an immediate cash payment called a premium. The key here is the word “covered.” Your obligation to sell the shares is covered because you already own them. This stands in stark contrast to selling a “naked” call, where you don't own the underlying stock, a speculative move that exposes you to potentially unlimited losses. For the patient investor, a covered call is a clever way to generate extra income from stocks you're holding or to set a target selling price for a position.

At its heart, a covered call is a simple trade with two potential outcomes. It's a fantastic way to understand the basics of options without taking on excessive risk.

To execute this strategy, you need two things:

• The Shares: You must own at least 100 shares of a single stock. (In the world of options, one standard option contract almost always represents 100 shares of the underlying stock).
• The Option Sale: You sell one call option contract for every 100 shares you wish to “cover.” When you sell the option, you and the buyer agree on the strike price and the expiration date. You immediately collect the premium, which is yours to keep, no matter what happens next.

Once you've sold the call, one of two things will happen by the expiration date.

If the stock's market price is below your chosen strike price at expiration, the option is “out-of-the-money.” The buyer has no reason to purchase your shares at a higher-than-market price, so the option contract will expire worthless.

• The Result: This is often the ideal outcome. You keep the original shares, and you keep the entire premium you collected. You've successfully generated income from your stock, effectively lowering your cost basis or boosting your total return. You can then repeat the process if you choose.

If the stock's market price is above your chosen strike price, the option is in-the-money. The buyer will almost certainly exercise their right to buy your shares at the agreed-upon (and now lower) strike price.

• The Result: Your shares get “called away.” You are obligated to sell your 100 shares at the strike price. Your total profit is the sum of two parts: the capital gain on your shares (the difference between your purchase price and the strike price) plus the option premium you received. While you miss out on any gains above the strike price, this outcome fulfills the goal of selling at a specific target.

Investors are drawn to this strategy for a few very practical reasons.

The premium you receive acts like an extra dividend. For investors holding solid, steady companies that aren't expected to shoot for the moon, selling covered calls can be a systematic way to squeeze extra return from an otherwise sleepy stock. It's a way of getting paid while you wait.

This is an elegant way to enforce selling discipline. If you believe a stock you own has reached its fair value at, say, $50, you can sell a call option with a $50 strike price.

• If the stock never hits $50, you keep the premium and the stock.
• If it rises above $50, your shares are sold at your target price, and you get to pocket the premium as a bonus.

The premium you collect provides a small cushion if the stock price falls. For example, if you receive a $2 premium per share, the stock can drop by $2 before you start losing money on your original investment. Bold: This protection is limited. A covered call will not save you from a major crash in the stock's price; it just softens a small blow.

For a value investor, the covered call is a tool to be used with intention, not just a machine for generating income. The core of value investing is buying wonderful businesses at fair prices, and the focus should always remain on the quality of the underlying asset. A value investor might use a covered call when a company they own is no longer undervalued and has approached its intrinsic value. Selling a call with a strike price at or slightly above this estimated intrinsic value can be a disciplined way to exit the position. However, there is a significant risk a value investor must consider: Opportunity Cost. If you sell a covered call on a fantastic compounding machine that is still in the early stages of its growth, you cap your potential upside. If the stock unexpectedly soars, you will be forced to sell at the strike price, missing out on what could have been a legendary gain. For this reason, many purists would argue against using covered calls on their highest-conviction, long-term holdings. It's a strategy best suited for mature, fairly-valued companies, not your potential “ten-baggers.”

Let's put it all together.

1. The Setup: You are a value investor who bought 100 shares of a stable utility company, “EuroAmerican Power,” at $45 per share. The stock has slowly risen and now trades at $50. You believe it’s now fairly valued, and you'd be happy to sell it if it hit $55.
2. The Trade: You sell one “EuroAmerican Power” call option contract that expires in one month with a strike price of $55. For selling this option, you immediately receive a premium of $2 per share, for a total of $200 ($2 x 100 shares).
3. The Potential Outcomes:
   • Outcome A: Stock closes at $54. The option expires worthless. You keep your 100 shares of EuroAmerican Power, and you keep the $200 premium. You've made a 4% cash return on your $5,000 position in just one month.
   • Outcome B: Stock closes at $60. Your shares get called away. You must sell them at the $55 strike price. Your total profit per share is the $10 capital gain ($55 sell price - $45 buy price) plus the $2 premium. That's $12 per share, for a total profit of $1,200. You successfully sold at your target price, but your opportunity cost was the extra $5 per share gain (from $55 to $60) that you missed.