The primary objective of employing a covered call strategy is to capitalize on the anticipated increase in the value of the underlying asset up to the chosen strike price. Investors who utilize this strategy receive an upfront premium in exchange for the obligation to sell their shares at the strike price. The addition of the short call caps the unlimited gain potential of the shares through the expiration period. Investors who utilize this strategy believe that the asset's price will rally to the strike price, and therefore are neutral with a slight bullish directional bias

Trade Anatomy & Example

Disclosure: Example for educational purposes only and does not include commissions and fees.

Imagine that you, as an investor, have a bullish sentiment toward ABC stock. You anticipate that ABC's current price of $100 will increase, possibly reaching $110. With this sentiment, you decide to employ a covered call strategy. You first purchase 100 shares of ABC at $100 per share. The option trade is then entered as ‘sell to open’ indicating that the short call is sold to create, or in other words, open the position. Therefore, you sell to open 1 ABC $100 strike call for a premium of $3 ($300 total). This means you are obligated to sell 100 shares of ABC at $100 per share at any time through the expiration period and received a premium of $3 per share for this obligation.

Remember, an option premium is comprised of intrinsic value and extrinsic value. Which means that option’s price is affected by more than just the underlying security, time and implied volatility also impact the option premium. Understanding the external impacts helps establish a sentiment and entry and exit strategies.

Disclosure: Example for educational purposes only and does not include commissions and fees.

Impact of Time Value Depletion

One critical aspect of the covered call strategy is time decay. The time value of the premium paid for the option (in this case, $3) diminishes as the option approaches its expiration date. This means that the longer it takes for the stock price to move in your favor, the more time value depletion will positively impact your position. This allows you to ‘buy-to-close’ the option at a lower price than it was initially sold for.

Risk is Created from Implied Volatility

As a covered call contains a short call, you do not benefit from an increase in implied volatility. When implied volatility rises, options premiums tend to expand. As the intend of the short call is to close at a lower price, this means the short call holder may expect a decrease in implied volatility.

Gain & Loss Scenarios

To add clarity, let’s look at various scenarios when a covered call is at a gain, loss and breakeven at expiration. Upon order entry, closing transactions are entered as ‘buy to close’ indicating that you intend to exit the position or in other words close the position

Suppose ABC stock rallies beyond your target price of $110 by $5 to $115 on the expiration date of the call option. In this scenario you hold an in-the-money option at expiration. An in-the-money option contains intrinsic or in other words, executable value.

• You have the obligation to sell your ABC shares at the $110 strike price.
• Your stock gain is the difference between the cost of the shares ($100) and the strike price ($110), which is $10 per share.
• The total capital appreciation realized is $10 x 100 shares = $1,000.
• Add the premium received ($3 x 100 shares = $300), and your net profit is $1,300.

In this scenario, the stock rallied above your target price of $110, which is where the strike price was established. This is how the option caps the gain potential of the long shares and why choosing a price target you are willing to sell your shares at is important.

At expiration, your contract is generally only worth its executable value. In this example, you hold an in-the-money option with $5 of executable/intrinsic value as the long call holder could execute upon the terms of the contract and purchase ABC at $110 per share and immediately sell at the market price of $115 per share. This means that you should be able to buy to close your contracts for at least $5 per share. Closing out the option will remove the obligation to sell, and you will keep your long shares. The net transactions will result in the same net profit. (stock appreciation of $15 per share, minus the $5 cost to close the contract, plus the original premium received of $3 = $13 per share) It is important to note that an option's price fluctuates through the day of expiration. By holding the option to the expiration date, you will have forgone any time value purchased.

If ABC stock fails to rally above the $110 strike price by expiration, your short call option expires worthless, and you will realize your maximum profit potential on the short call and keep the entire up-front premium of $3 ($300 total). However, as this is a covered call, we must consider the long shares. If ABC stock declines more than the $3 premium received, the long shares will begin to incur a loss. In this case, ABC stock declined by $5 per share. Therefore, the loss on the stock is $5 x 100 shares = $500. The loss is then offset by the $3 premium received, resulting in a net loss of $2 per share or $200 total.

You hold an out-of-the-money option on the day of expiration. It will be difficult to buy to close the contract as there isn’t any intrinsic value and the time value component has completely diminished. Therefore, the contracts will likely expire from your account as worthless and you will keep your 100 shares.

Your covered call strategy breaks even when the stock price declines by the premium received. In this case, it's $100 (cost of stock) - $3 (premium) = $97. If ABC closes at $97 at expiration, you neither gain nor lose money. Your option will expire worthless, and you will realize your maximum gain potential of $3 per share. However, the option will have a loss of $3 per share. The positions netted together offset any gain or loss.

In this scenario, you hold an in-the-money option at expiration, you should be able to close the contracts on the market for the executable value of $3 per share. Remember, executable valuable represents the contract’s intrinsic value.

Holding a short option on the day of expiration

It is important to note in these examples the option was held on the day of expiration. This adds another layer of risk as in-the-money options will auto-exercise/assign on the day of expiration as means to capture any value contained within the option. You are not obligated to hold your option until the day of expiration. If you do not wish for your shares to be called away or sold, you can close out your short option at any time as long as a market exists.

Before expiration, the value of your short call option will fluctuate with changes in the stock price, implied volatility, and time depletion. If ABC rallies above $100 but falls short of your $110 price target, your option may still have some value. Your gain or loss will depend on the current market price of ABC compared to the strike price and the remaining time to expiration. Therefore, it is prudent to consider the external factors that affect your options price in addition to your sentiment of the underlying security. Remember, when you create a covered call, you create an obligation to sell your shares at the strike price. This allows you participate in capital appreciation and create additional yield via the premium. Therefore, you must consider the price at which you are willing to sell your shares at in addition to the yield you are creating by the up-front premium received.

By understanding these scenarios and how they apply to your covered call position, you can make informed decisions, set realistic price targets, and manage your risk effectively when implementing this neutral to bullish strategy.