Covered calls

A covered call is a call on stock you own

You own a stock that isn't doing much. Can it pay you while you wait? Say Dana owns 100 shares she bought at $44. She'd be happy to sell them at $45.

So she writes, which means sells, a 45 call for 2. She collects 2 times 100 shares, $200. She keeps it whatever happens. That's a covered call. A covered call means you own the stock and write a call on it.

It's covered because the shares cover her. If she's assigned, she must sell at 45, and she hands over shares she already owns. It fits someone who expects the stock to stay flat or rise a little. The exam calls that neutral to slightly bullish.

Don't confuse it with an uncovered call. An uncovered writer owns no stock, so a big rise hurts. A covered writer's risk is the stock falling. A covered call means you own the stock and write a call on it. You collect the premium now.

In a covered call, the premium lowers your cost

Dana owns stock and wrote a call against it. Where does she break even? A covered call means you own the stock and write a call on it. Dana bought at 44 and collected 2 for a 45 call.

Dana received the premium. Money coming in lowers what the stock really cost her. So her breakeven is the stock cost minus the premium. 44 minus 2 is 42.

Her worst case is the stock falling to zero. She loses 44 a share, less the 2 she kept. Times 100, that's $4,200. Notice both numbers start from the same place: the stock cost minus the premium.

The slip is adding the premium, as if Dana paid it. She didn't pay it. She received it. The premium softens a drop only by what she collected. For real protection against a fall, you'd buy a put.

For a covered call, the premium lowers your cost. Breakeven is the stock cost minus the premium.

In a covered call, your gain stops at the strike

Dana's stock takes off. How much can she make? A covered call means you own the stock and write a call on it. Dana owns 100 shares bought at 44, and wrote a 45 call for 2.

Say the stock rises to 60. The call buyer exercises, because buying at 45 beats paying 60. Dana is assigned, so she must sell her shares at 45. People say the stock is called away.

She makes 1 a share on the stock, from 44 to 45. Add the 2 premium she kept. That's 3 a share, or $300. It's $300 whether the stock ends at 60, 80 or 100. Above the strike, her gain stops growing.

The rule: maximum gain is the strike, minus the stock cost, plus the premium, times 100. The slip is calling the upside unlimited. Writing the call traded that upside for the premium.

A covered call pays you the premium now. In return, your gain stops at the strike.

Worked example: Covered call: three numbers

1. You buy 100 shares at 55 and write a 60 call for 2.50. Find the breakeven, the maximum gain and the maximum loss.
2. Breakeven first. The premium came in, so it lowers your cost. 55 minus 2.50 is 52.50.
3. Next, the maximum gain. The stock can rise 5 before it's called away at 60. Add the 2.50 premium for 7.50. Times 100, that's $750.
4. Last, the maximum loss. If the stock goes to zero, you lose 55 less the 2.50 you kept. 52.50 times 100 is $5,250.
5. Notice that the breakeven and the maximum loss both start from the same number: cost minus premium.

Common mistakes

The premium lowers your cost

Added the premium to your cost? Flip it. A covered call writer receives the premium, so it lowers the cost of the stock. Breakeven is the stock cost minus the premium.