What is a Covered Call
When writing (selling) a call, you assume an obligation. What duty? A delivery obligation. When you write a call, you assume the obligation to deliver the underlying asset. When writing calls, you have not bought a right, but you have assumed a duty! And the latter is very important for you to realize. When you buy options you have acquired a right, but when you sell options you enter into an obligation.
In the case of writing a call, you enter into a delivery obligation! You commit yourself to potentially having to deliver the shares at the strike price you have written. Your reimbursement for this is the premium received. Because of course you are not going to take on a duty for nothing. If you write the call 25, you may be required to deliver the share for €25. Your compensation for this is the option premium received.
Never write calls without owning the underlying asset! If you write calls without having the underlying asset, the company could theoretically be taken over and that could go up to twice the current price. You are then obliged to deliver the shares at the exercise price.
Why would you want to write calls?
Writing calls on existing shareholdings provides additional returns. You (possibly) sell the shares that you own in the future because you enter into a delivery obligation. This means that if the share rises sharply, you have to deliver the shares, but you had already taken this into account when selling the call. It is of course also possible that you do not have to deliver and at that time you can put the received premium in your pocket.
Let's take a look at an imaginary ABC stock. The stock is currently trading at €25.33 and you would like to write a call with six months maturity to make some extra return. The call ABC 26 (so you should deliver for €26) yields €0.65. So if you decide to sell this call, you will have to deliver the share to the stock for $26. But because you received $0.65 for this commitment, you are actually selling at $26.65.
What does this mean?
If you were to sell this call, you would therefore enter into a delivery obligation at $26 and you would receive $0.65 for this. This obligation runs until the third Friday of the expiry month.
If the share is below €26 on that third Friday, you can pocket the premium received. Then you can look for the next call to write.
If the stock is above €26, you will be required to deliver the shares for €26. You can be released from this obligation by buying back the call. If you do, you can also decide to immediately sell another call with a higher strike price. This is called roll-over.
When are you happy with this commitment you are taking on?
The optimal scenario is one in which the share rises to $26. You then make a profit on the share as well as on the written call. Because the right to buy at $26 is worth $0 if the share is also listed on the stock exchange at $26 on the third Friday of the expiry month.
When are you not happy?
If the stock is going to rise sharply. In that case, you still have to deliver at $26, while the share on the stock exchange may be worth $31. So you are missing out on profit. And make no mistake, you will not be forgotten and you do have to deliver for $26
If the share goes down very sharply, that is very disadvantageous. It is true that you have received $0.65 for the delivery obligation that you have entered into, but if the share falls by $5, the $0.65 received is only a very limited buffer.
When do you write a call?
If you own the stock and don't really expect a big market movement. You can then make extra return on your share ownership by writing calls. In the most optimal scenario, the share rises to the level just below the level where your obligation lies.
What is your maximum risk?
Your maximum risk occurs with a (very strong) fall. It is true that you have received the option premium, but in the event of a large decline, this offers only limited relief for the loss you incur on your shareholding.
In the worst-case scenario, the company goes bankrupt and your shareholding has become worthless. The only thing you can put in your pocket is the premium received, but of course that is not proportional to the loss you have suffered on the share.
If you own the shares, you can decide to write calls on them. You thus enter into a delivery obligation, but you will receive a premium (money!) for this. This strategy works well in sideways moving markets because then you are taking on an obligation that you are not held to, but you will receive money for it.