Covered call

Article contents



At a glance



Setting up the strategy


  1. Buy 100 shares of an underlying stock.

  2. Sell a call option on the same underlying stock.

Who should run this?


Ideal for all traders, from novice to advanced.

Margin requirements


Learn more about Questrade’s option margin requirements.

Strategy overview



A covered call is an option strategy in which a trader holds a position on a stock and subsequently sells a call option on the same stock in order to produce supplementary earnings from the asset.   

When you sell a call option, you are obligated to sell the stock you already own at the strike price if the buyer exercises the call option. 

Market outlook


  • Slightly bullish or slightly bearish (if selling a covered call)

Strategy benefits


  • Receive income from the option premium when you sell call options.
  • Offset losses if your stock depreciates in value.

Strategy downsides


  • May lose your stocks if the stock value rises beyond the strike price of the option.
  • Even if your stock goes up significantly, the upside is capped by the strike price, plus the option premium received.
  • If the stock goes down significantly, the option premium you receive will not be enough to offset your losses.

Covered call example



Scenario


You own 100 shares of ABC stock valued at $45. In the short term (less than 30 days) you expect the stock price to rise slightly to a maximum value of $48. 
You sell a $50 call option on ABC stock that expires in 30 days, which earns you an option premium valued at $100 (1.00 option premium x 100 shares = $100).

Note: one options contract = 100 shares.

This means that the buyer of the call option has the right to purchase the stock at a $50 strike price before the 30-day expiration date.

Possible results


  1. ABC shares go up slightly for the next 30 days, rising to $47.50, but still well below the strike price of $50. The $50 call option expires worthless, and you keep the call option premium ($100), plus you earn an additional $250 because the shares went up $2.50. Your total profit would be $350.

  2. ABC shares drop to $44, meaning the call option expires worthless, and you keep the 
    call option premium ($100). However you lose $1 per share ($1 x 100 = $100) because the share price dropped from $45 to $44. Since the option premium offsets the share depreciation, you break even.

  3. ABC shares rise to $52, slightly above the $50 strike price, meaning the call option is exercised by the buyer. Although your profit upside was capped at $50, you miss out on an additional profit of $200 ($2.00 x 100). Still, this gives you a total profit of $600.

  4. ABC shares drop to $40, well below the strike price, meaning the call option expires worthless. Although you keep the option premium ($100), you incur significant loss owning the shares themselves ($5 x 100 = $500). Your total loss would be $100 (call option premium) - $500 (share depreciation) = -$400.

Profit and loss explained



Maximum profit


Maximum profit = [(strike price – stock purchase price) x number of shares] + (option premium x number of option contracts x number of shares per contract)

Maximum loss

Maximum loss = (stock purchase price x number of shares) – (option premium x number of option contracts x number of shares)

Although you receive a premium when you sell the call option, the most risk comes from owning the shares themselves because the stock may actually drop in value until the option expiry date. 

Break-even at expiration


Break-even point = stock entry price – option premium

Sample calculations



  • Stock value at start of strategy: $45
  • To execute the strategy: sell $50 call option for $100
  • Result: $100 net credit
Stock price at expiration Profit and loss calculations 
$40

$1.00 (option premium)

–  $5.00 (share depreciation)

x 100 (number of shares)

= $400 loss 
$44

$1.00 (option premium)
x 100 (number of shares)

– $1.00 (share price drop)

x 100 (number of shares)

= $0 (break-even)

$45

$1.00 (option premium)

x 100 (number of shares)

= $100 profit 

$48

$1.00 (option premium)

x 100 (number of shares)

+ $3.00 (share appreciation)

x 100 (number of shares)

= $400 profit 
$52

$1.00 (option premium)

x 100 (number of shares) 

 + $5.00 (share appreciation capped at $50 strike)

x 100 (number of shares)

$600 profit


Note
: commission fees are not included in the above calculations.


Covered call payoff diagram





Creating a covered call





Standard order details

Order detail

Description

Symbol lookup field

Click  and change the mode to . Then enter the symbol you want to buy or sell. The default expiration date, strike price, and strategy appear. 




Tip: click the Option tab to view a more detailed option quote.

Modify the expiration date, strike price, and option strategy accordingly. For more information, see Elements of an option quote.
Action

The buy or sell action is set for you when you select the strategy type.

Qty

Select a value using the arrows , or enter a value manually.

Note: by default, the quantity will be populated with the value set in your user preferences.
Order type Select the type of order you want to submit. When creating strategy orders, only Limit or Market order types are available. For more information, see Order types.

The limit order type requires you to fill in additional fields. Refer to the table section below for details.
Duration

Select a duration to specify how long the order should remain active. For more information, see Order durations.

Route Select a route or leave the selection at Auto to let the platform determine the best one. Canadian routes will be listed for Canadian symbols and U.S. routes will be listed for U.S symbols.
Sub-route

This field will be filtered according to the route selection. It indicates where you prefer the order to be executed. Leave the selection at Auto to let the platform determine the best route.

Note: sub-route selection is only available for Canadian symbols.
Order type-specific details
Limit price Enter your limit price:

  • To have the price fluctuate according to real-time data, select . The icon changes to a lock icon , which locks the limit price. Once locked, use the refresh button to automatically update your limit price.
  • To choose a custom price, select .
Note: if real-time market data is not available, the limit price will be blank and the float limit icon will be unlocked.






Note: the video tutorial above shows how to create a covered call strategy using IQ Edge; however, the principles are the same for IQ Web.
Tip: for an optimized viewing experience, watch the video on YouTube in full 720p HD. To open the video in YouTube, click the YouTube button in the bottom right corner of the video window and select the change settings icon to modify the video quality.


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