6 Benefits of Covered Calls: A Simple & Powerful Options Trading Strategy

From small retail traders and financial advisors to hedge funds, covered calls are a neutral to bullish strategy and are one of the most easily understood and most commonly used option trading strategies, and for good reason.

Easy to implement and adjust, the ability to provide consistent returns over time, and lowering overall cost basis are but a few of the powerful benefits of covered calls that we’ll explore in this article.

What is a Covered Call?

A covered call is an options trading strategy that requires ownership of an underlying asset such as shares of a company, a cryptocurrency, etc. (we’ll explore the differences of how a covered call strategy works between these two assets), and simultaneously selling an equal or lesser amount of call options on the asset.  

In essence, the trader has their position “covered” by holding the underlying asset, hence the name and the biggest benefit of a covered call.

In the traditional understanding of covered calls in the equities world, the call option sold is a contract that gives the buyer the right, but not the obligation, to purchase the shares from the seller at a predetermined price (strike price) within a specified time frame (expiration date).

How a Covered Call Works: Equities

Let’s look at a simple example of a covered call where an investor owns 100 shares of a stock, currently trading at $50 per share.  After reading this article on the benefits of covered calls, the investor decides to implement the strategy and sells a call option with a strike price of $55 that has an expiry date of 30 days in the future.

Note that a single (1) call option was sold, and almost always represents 100 shares of the underlying stock.

In exchange for selling this call option, the investor receives a premium, which is the price the buyer pays for the option.

If the price of the stock remains below $55 by the expiration date (30 days in the future), the call option will expire worthless, and the investor will keep the entire premium received.

However, if the stock price rises above $55, the buyer of the call option may choose to exercise the option, meaning that the investor would need to sell their shares at the strike price of $55. 

It’s extremely important to mention here that the seller of the covered does not have to sit on their hands and wait for the option to expire.  At any time prior to expiry, the option can be bought back.  In fact, we rarely allow an option to go to expiry. 

There are many reasons why an option can and should be bought back prior to expiry, but in the case of covered calls specifically, it’s more common for some investors to allow them to expire, such as when conducting a covered call campaign.

How a Covered Call Works: Cryptocurrency

As many of our readers know, we also trade a lot of cryptocurrency options. For us, we don’t really care too much about the underlying asset, it’s just another thing to trade, and crypto has consistently provided great opportunities over the past few years, so let’s look at how a covered call would work when the underlying asset is a cryptocurrency such as BTC or ETH.

Let’s say that a trader bought 1 BTC at $29,000 and immediately sold 1 BTC call option with a strike price of $33,000 that expires in 30 days (note that with BTC, you can trade fractionally, meaning that you can own less than 1 full BTC and still sell covered calls against it, something that is not readily available with stocks).

As always, when the call option is sold, the seller receives a premium, and if the price of BTC remains lower than $33,000 at options expiration, the seller would keep it all.

However, unlike with stock, if the price of BTC rises above $33,000, most cryptocurrency options are cash-settled (as are index options).  This means that the call buyer cannot “call away” 1 BTC from the call seller and force them to sell it to them at the strike price.

When an option is cash-settled, the difference between the strike price and the market price of the asset at expiry is debited from the seller's account (if the market price is above the strike price at expiry), meaning that the call seller would lose that difference minus the premium received, but still owns the 1 BTC.

Benefits of Covered Calls

1. Income generation: The primary benefit of covered calls is the potential to generate consistent income, often achieved through a covered call campaign.Through the act of selling call options, the seller receives premiums, regardless of whether the options are held to expiry, bought back prior to expiry, exercised, or cash settled.While strike and expiry selection may vary in low vs. high implied volatility environments, a steady and consistent stream of revenue in the form of premiums can be realized.
2. Cost basis reduction: Every time a covered call seller sells a call option, the premium received can be viewed as reducing the cost basis of the underlying asset by that amount.For example, in our example, a trader bought BTC at $29,000 and then sold a $33,000 call. If the premium received for that call option was $500, the cost basis of the BTC would be reduced by $500.If we had 2 traders who bought BTC at the same time at $29,000 where one executed a covered call, and the other didn’t, the covered call seller would have a new cost basis of $28,500, if the price of BTC stayed below the strike price at expiry.So theoretically over time, the cost basis of an asset could be reduced to zero.
3. Enhanced portfolio returns: Covered calls can provide an additional stream of income on top of the potential appreciation (and dividends in the case of some stocks) of the underlying asset, enhancing portfolio returns.
4. Downside protection: Much like reducing cost basis, premiums received from selling covered calls provide a buffer and help to offset any decline in the value of the underlying asset.
5. Flexibility: Covered calls offer flexibility and tailoring risk according to goals, risk tolerance, and market conditions through the choice of strike prices and expiry dates. Plus, they’re easily adjusted mid-strategy if required as market conditions change.
6. Utilization in sideways or rising market conditions: Selling covered calls can be profitable in both sideways and rising market conditions. 

Limitations of Covered Calls

1. Limited Upside Potential: While a covered call strategy can offer income and some amount of downside protection, it does cap the potential gains a trader can make if the underlying asset price experiences significant growth in a short period of time.
   
   If the underlying price shoots up quickly, the covered call seller is obligated to sell the underlying at the strike price (in the case of stocks and if held to expiry), missing out on potential profits.There are of course ways of effectively dealing with this scenario by adjusting the covered call.
2. Assignment Risk & Opportunity Cost: When writing covered calls with equities, there is the risk of assignment. If the stock price exceeds the strike price, the call option buyer would exercise their option, forcing the call option seller to sell their shares at the strike price.
   
   In the event of a significant price increase of the underlying asset, this would be a missed opportunity for the covered call seller because the gain in the underlying asset would outweigh the amount of premium received through the sale of the call option.
3. Market Volatility: Volatility affects option prices, so a trader must be cognizant of the current volatility environment and be prepared to potentially adjust the covered call strategy as conditions change.
4. Downside Risk: While one of the benefits of covered calls is receiving premiums that serve to reduce downside risk by reducing the overall cost basis, the strategy is still susceptible to downward price moves.In fact, if we’re extremely bearish on an asset, we prefer to sell the asset vs. selling a covered call.

Conclusion

Covered calls are a simple and useful approach to trading and investing that combines income generation, downside protection, and enhanced returns.  While the strategy has strong benefits, like all strategies, it is not without limitations.

Traders must weigh the potential gains against the inherent risks and be prepared to adapt their approach and potentially adjust the trade based on market conditions.

By having a full understanding of the mechanics, benefits, and limitations of the covered call strategy, traders can make informed decisions and potentially capitalize on the opportunities that this strategy provides.