Understanding a Covered Call

One of the best ways to understand the rewards and risks of a trade is to plot a risk graph. Below is the basic risk graph associated with a covered call strategy.

Plotting Risk Here's the risk graph for the covered call strategy

This is just the opposite of what we want to see from a risk graph. We'd prefer to enter a trade that has limited risk and unlimited reward. It's not just the fact that this trade has unlimited risk, but that this risk is of high dollar amounts as well.

For example, if you buy 100 shares of stock that costs $25 a share, you would have $2,500 at risk. However, if you buy an option to control these 100 shares, your cost (risk) would be around $400. I don't know about you, but I'd rather have control of 100 shares of stock for $400 than be at risk of losing up to $2,000. Even if margin is used, you'd have to put out $1,000 and if the stock were to drop, more money would be needed to cover the drop in price.

When is it alright to use a covered call? For traders who have long-term holdings, selling calls to bring in premium might be a reasonable choice. However, if you sell calls against long-term holdings, you're taking the chance of having to sell the stock if it reaches a certain price. Nonetheless, this can be a good way to bring in income if you expect the stock to move slightly down in price or if you expect it to trade sideways.

Of course, if you expect a sharp decline, you would be better served to buy puts, use a collar or sell the stock. One thing that's discouraging when selling covered calls against long-term holdings is when the stock rises sharply. In this case, a stock you've been waiting to rise finally does, but you don't make profits on the gains because you have short calls that need to be covered.

Of course, you could buy the calls back, but the net effect is still a loss of the profits. But if you're willing to sell your stock at a certain price overhead and were planning to hold it even if it declined, then selling calls against these holdings could be beneficial.