Covered calls

The covered call is the most widely used option strategy among people who own stock, and the most widely misunderstood. It is sold as "getting paid to own shares". What it actually is, by put-call parity, is a short put with extra steps. Once you see that, both its appeal and its limits are clear.

The structure

Own 100 shares of XYZ at $50. Sell one 30-day $53 call for $0.75 ($75).

• You keep the $75 no matter what.
• If XYZ is at or below $53 at expiration, the call expires worthless and you still own the shares.
• If XYZ is above $53, you are assigned: your shares are sold at $53. You keep the $75 plus the $3 per share gain from $50 to $53.

The full P&L at expiration, per 100 shares:

Covered call: long stock at 50, short 53 call for 0.75
 P&L
 +375 |                       ___________________
      |                      /
    0 |--------------------X----------------------  X = 49.25
      |                  /
      |                /
 -925 |______________/
      +----+----+----+----+----+----+----+----
      40   44   48   52   56   60            XYZ at expiry

Maximum profit: $375, reached at $53 and capped there forever. Breakeven: $50 − $0.75 = $49.25. Maximum loss: $4,925 if XYZ goes to zero. The shape is a flat top and a long downside slope, which is exactly the shape of a short $53 put.

What the $75 is

The $75 is compensation for giving up every dollar above $53. In the table, at $55 you are $125 worse off than a plain stockholder; at $60, $625 worse off. Over many months, the covered call writer collects a stream of small premiums and periodically misses a large rally. Whether the trade-off is favourable depends on whether the premiums collected exceed the upside surrendered, which depends on realized versus implied volatility (Module 4) on the upside specifically.

Historically, on broad indices, systematically writing calls has produced returns somewhat below buy-and-hold with lower volatility. That is a reasonable outcome for some investors and a disappointing one for anyone who was told it was "extra income". It is a trade of upside for premium, not free money.

The downside is not reduced

Look at the $40 row: −$925 versus −$1,000. The premium cushioned the loss by $75, or 7.5%. Covered calls do not protect against a fall; they slightly reduce it. If XYZ is a stock you would not want to hold through a 20% drop, selling a call against it does not change that.

Key idea: A covered call is a short put in disguise. It caps the upside at the strike, cushions the downside by only the premium, and its "income" is payment for the rallies you will miss.

Choosing the strike and expiry

The decision mirrors Module 5 in reverse:

Expiry: 30 to 45 days captures the steep part of the decay curve for the seller while leaving enough premium to be worth the commissions and the spread. Weekly calls collect more per year in theory but require weekly attention and more transaction cost, and give you many more chances to be assigned right before a large move.

When the stock runs past the strike

Three options, none of them free:

• Let it be assigned. Sell the shares at $53, keep the premium. Clean, and the tax and dividend implications are covered in lesson 3.
• Buy the call back. If XYZ is $56 with a week to go, the $53 call is about $3.20. Buying it back costs $320 against $75 received, a $245 loss on the option, offset by the unrealised $600 gain on the stock. You are back to plain stock, having paid $245 for the privilege.
• Roll up and out. Buy back the $53 call, sell a $56 call further out, usually for a net debit or a small credit. This delays the decision and often ends with the same problem a month later, one strike higher.

Decide before selling the call which of these you will do. "I will let it go at $53" is a decision; "I will figure it out" is a loss waiting for a name.

A worked year

XYZ at $50, IV 30%. You sell a 30-delta call every 30 days for about $0.75, twelve times a year: $900 of premium, or 18% of the initial stock value. Realistic outcomes over that year:

The strategy shines in chop and modest trends, and underperforms sharply in a strong year for the stock. If you would be upset to sell XYZ at $53 while it goes to $65, do not write the call.

Try it: For a stock you own or would own, sell (on paper) a 30-delta call 30 to 45 days out. Compute breakeven, max profit and the P&L at −15%, 0%, +5% and +15%. Then write down, in advance, what you will do if the stock is 5% above the strike with a week to go.

Recap

• Covered call = long stock + short call = short put at the strike, by parity.
• Max profit is capped at strike − cost + premium; breakeven is cost − premium; the downside is the full stock risk minus one premium.
• The premium is payment for surrendering upside above the strike; over time the strategy trades big rallies for small regular credits.
• Choose the strike by delta (0.25 to 0.30 is common) and the expiry at 30 to 45 days.
• Decide before entry what you will do if the stock runs through the strike: be assigned, buy back, or roll.