What are covered calls and why are they so popular? September 12, 2023

What are covered calls and why are they so popular?

Table of Contents

  1. Introduction
  2. Understanding Covered Calls
  3. Benefits of Covered Calls
  4. Popularity Factors
  5. Potential Drawbacks and Risks
  6. Conclusion


Introduction

About 40 million options contracts are traded daily, demonstrating the widespread adoption and appeal of options. In May 2023 alone, the Options Clearing Corporation (OCC) managed a remarkable 949.1 million contracts, highlighting the substantial volume and engagement in this market.1 To put this into perspective, the options market competed closely with the New York Stock Exchange’s daily volume, with an average of about 38.3 million contracts traded per day in 2022. So what exactly are the options?

As the name suggests, “Options” provide investors with a range of investment avenues, allowing them to adapt their strategies to the prevailing market conditions. If you’d like to learn more, take a look at our earlier market journal about POEMS US Options Trading.

Understanding Covered Calls

Well, how do options and Covered Calls come into play?

A Covered Call is a combination of owning the underlying shares while simultaneously selling a call option. In return for selling this call option, the seller will receive a premium from the buyer, providing an immediate income for the seller.

Unlike stock dividends, the premium received when selling a call option is not subjected to taxation. This collected premium can be promptly utilised to purchase shares or options right after the call option is sold. This advantage is one of the many reasons why the Covered Call strategy is widely employed and popular among experienced investors.


To help with your understanding, Here is an illustration of how Covered Calls work:

John bought 100 Tesla shares(US: TSLA) at US$200 per share. He then decides to sell a call option with a strike price of US$220 with an expiration date of one month from now. This means that John will be receiving a total premium of US$1000 (US$10 x 100 shares) for selling the call option.

With reference to the graph below, there are two scenarios that could play out for John upon after adopting a Covered Call strategy

What are covered calls and why are they so popular?Source: POEMS
Last Updated: 5 October 2023


Scenario 1: Stock Price Below Strike Price (US$220)

Firstly, if the stock price is below the strike price, the call option will likely to expire worthless for the buyer. In this case, the seller, John, will keep the premium collected from selling the option and retain ownership of the shares. John will also have the option to roll forward the contract by opening another Covered Call( a strategy known as the “Wheel Strategy”). This flexibility is another reason why Covered Calls are popular, as investors can continuously generate income through the sale of call options while holding onto the shares they wish to keep.


Scenario 2: Stock Price Above Strike Price (US$220)

Alternatively, if the stock price rises above the strike price, the call option buyer may choose to exercise the option and buy the shares at the strike price from John. In this case, John is obligated to sell the shares at the strike price but keeps the premium collected. This would amount to US$220 per share + US$1000 premium from the Covered Call. It’s important to note here that the potential downside of using a Covered Call strategy is the limit of John’s profit potential should the stock price continue to rise beyond US$220


Benefits of Covered Calls

As mentioned earlier, Covered Calls offer a way for investors to generate income while retaining possession of the underlying shares during a stagnant market. They have the potential to boost yields, especially for stocks that do not typically pay dividends and also allow the seller to take additional profit on top of the strike price. The income generated then helps to reduce the underlying shares’ cost basis.

A Covered Call strategy is also adaptable to various market conditions depending on the investment goals and current market conditions. In a bullish market, a Covered Call strategy can be used to set profit-taking targets for investors and to collect additional premiums. In a neutral to bearish market, investors can still generate income by selling the call options while retaining the shares.

However, the main reason why investors sell Covered Calls is to actually take advantage of the time premium. Time premium is the portion of an option’s premium and price that is associated with the time remaining until the option’s expiry and it diminishes as time passes. To take advantage of this time premium when selling contracts, it is important to note that there is a period for exponential time decay typically within a period of 30 days to 45 days.2

What are covered calls and why are they so popular?


From the graph above, it is evident that there is an accelerated rate of time decay as the expiration date nears. By understanding this graph, it allows a call option seller to thoroughly evaluate the risk of holding the option through periods of uncertain market conditions. This assessment aids the seller in deciding the optimal selling price and managing the possibility of an assignment for the option.

Additionally, Covered Calls’ relatively straightforward nature makes them accessible and friendly to most investors including newcomers. Lastly, their value shines particularly in markets that lack directional movement, given their potential to amplify returns even when the market is consolidating.


Potential Trade-off and Drawbacks

While Covered Calls come with their advantages, they have a notable drawback often referred to as “limited upside” or “opportunity cost loss.” This happens when the seller has the obligation of selling the shares at the agreed-upon strike price to the buyer, forgoing potential profits should the share prices continue to rise. Nevertheless, investors still have the option to repurchase the shares if their price drops and the strike price can then act on a profit-taking level instead.


Conclusion

In summary, Covered Calls remain a popular trading strategy within options, providing investors with the means to realise profits in the prevailing market environment. They allow investors to generate extra yields while retaining shares they have a vested interest in.

If you think the Covered Calls strategy is something you are interested in or would like to trade options, subscribe to our US options live price feed FOR FREE on POEMS 2.0. Each subscription is valid for 12 months. Do note that without the subscription, option prices displayed are delayed by 15-30 minutes. If you want to open an account now, please refer to this instruction video.

For current account holders, in case you did not know, POEMS 3 provides US options trading capabilities. Therefore, if you want to explore how to engage in trading US stock options, watch the video to learn more.

Alternatively, for more information about options trading on POEMS, you can visit our website, or reach out to our Night Desk representatives at globalnight@phillip.com.sg / (+65) 6531 1225. Register for the Options account today!

Lastly, embark on an exciting journey with us in our vibrant Telegram community,where we can’t wait to unveil even more enlightening insights! Come join us today!


Reference:

  • [1] The Options Clearing Corporation (OCC). (2023, June 2). OCC Clears 949.1M Contracts in May 2023, Third Highest Month on Record. https://www.theocc.com/newsroom/press-releases/2023/06-02-occ-clears-949-1m-contracts-in-may-2023-third-highest-month-on-record
  • [2] Ianieri, R. (Jun 12, 2009). Options Theory and Trading. Wiley Trading.

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