What is a covered call strategy and when would you use it?
I see 'covered call' mentioned in the derivatives section of CFA Level I. I understand it involves owning the stock and selling a call, but I'm not sure about the motivation or the risk profile. When does it make sense?
A covered call is one of the most popular option strategies and a favorite CFA exam topic. It involves:
- Owning the underlying stock (the "cover")
- Selling (writing) a call option on that same stock
Why do it?
The primary motivation is to generate income from the option premium in a market where you expect the stock to be flat or modestly bullish. You're essentially renting out the upside of your stock position.
Payoff profile:
- Maximum profit: (Strike price - Purchase price) + Premium received
- Maximum loss: Purchase price - Premium received (stock goes to zero)
- Breakeven: Purchase price - Premium received
Example:
You own 100 shares of Beacon Energy, purchased at $80/share. You sell a call with a $90 strike for a $4 premium.
| Stock Price at Expiry | Stock P/L | Option P/L | Net P/L |
|---|---|---|---|
| $70 | -$10 | +$4 (expires worthless) | -$6 |
| $76 | -$4 | +$4 | $0 (breakeven) |
| $80 | $0 | +$4 | +$4 |
| $90 | +$10 | +$4 (assigned at strike) | +$14 (max profit) |
| $100 | +$10* | +$4 - $10 = -$6 | +$14 (capped) |
*At $100, you must sell at $90 (assigned), so stock gain is capped at $10.
Key insights:
- Income generation: The $4 premium provides income even if the stock doesn't move
- Downside cushion: The premium partially offsets losses (breakeven drops from $80 to $76)
- Capped upside: You give up gains above the strike price — if Beacon Energy surges to $120, you still sell at $90
When it makes sense:
- You're neutral to slightly bullish
- You want income from a stock you plan to hold anyway
- You're willing to sell at the strike price
When it doesn't make sense:
- You're very bullish (you'd miss the upside)
- The stock is extremely volatile (large downside risk only partially offset by premium)
For more options strategies, check out our CFA Level I derivatives materials.
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