Covered Call

Definition

The term covered call refers to a strategy in which the seller of a call option owns all of the underlying securities outlined in the contract.  Investors will do this when they do not believe the asset will increase in value over time, and would like to profit from the option premium.

Explanation

Also known as "buy-write," a covered call involves a transaction whereby the writer of the call agrees to sell a fixed number of securities at a specified price, and within a given timeframe to another party.  Call options typically involve securities such as stocks and bonds, as well as commodities.

The seller of a call option is referred to as the writer, who is obligated to sell the securities to the holder of the call option if they exercise their right.  The buyer of a call pays a fee, known as a premium, to own the right to exercise their option.  If the seller of a call owns a corresponding amount of the underlying security, the option is said to be "covered," which means the seller does not have to purchase shares on the open market if the buyer of the call decides to exercise their option.

Generally, the buyer of a call option is bullish on the security, since they believe its price will increase over time.  The writer of the option has a bearish or neutral view in the case of a covered call.  There are three possible outcomes when writing a covered call:

  • Flat Price:  the underlying security's value does not rise or fall over the term of the option, and the buyer of the call does not exercise their right to buy the securities.  When this happens, the writer of the covered call profits from the premium they received.
  • Declining Price:  the underlying security's value falls over the term of the option, and the buyer of the call does not exercise their right to buy the securities.  When this happens, the writer of the covered call profits from the premium they received.  However, since they own the underlying securities, they own an asset that is less valuable.
  • Increasing Price:  the underlying security's value increases over the term of the option, and the holder of the call exercises their right to buy the securities.  When this happens, the writer of the covered call profits from the premium they received.  Since they own the underlying securities, they also realized a profit on the sale of their securities.  However, the profit they realize is capped at the strike price.

Related Terms

call option, naked callnaked put, put option