Understanding the covered call option strategy

Key components of a covered call

Here is a summary of the key elements of a covered call strategy.

First, the futures contract is essential, as you must own one to use this approach. The position is considered "covered" because your ownership ensures that you can fulfil your obligation if the option is exercised.

Next is the call option, which has two important components. The strike price is the price at which the buyer has the right to purchase your futures contract, typically set slightly above the current market price. The expiration date defines the period in which the buyer can exercise their option, often aligning with a predetermined schedule, such as the third Friday of a month.

Finally, the premium is the upfront payment you receive for selling the call option. This amount is yours to keep regardless of how the market moves, making it a key benefit of the strategy.

Why would someone buy a call option?

A call option buyer believes the futures price will rise significantly. Call options provide a way to profit from price increases without taking on the full risk of owning the futures contract outright.

For instance, the buyer of your crude oil call option could make a considerable profit if futures prices rise above USD 80. If they paid only USD 1,000 for the option, any price above USD 81 per barrel (strike price plus premium) represents a profit.

This potential for upside gain is what makes call options attractive to traders.

The risks and rewards of covered calls

No investment strategy is without its pros and cons, and covered calls are no exception.

Here’s a balanced view of the potential benefits and drawbacks.

Potential rewards:

• Steady income. The premiums collected from selling call options can provide a reliable source of income, especially in stable markets.
• Downside protection. The premium serves as a buffer against small declines in the futures price. For example, if the futures price falls slightly, the premium offsets the loss, keeping your position more stable.
• Straightforward execution. Covered calls are simpler to understand and implement compared to other options strategies, making them a good choice for investors new to options trading.

Potential risks:

• Capped upside. If the futures price rises significantly above the strike price, your profits are limited. You miss out on additional gains beyond the strike price plus the premium.
• Futures price decline. While the premium provides partial protection, significant drops in the futures price can still lead to substantial losses. The premium only offsets a portion of the decline.
• Commitment to sell. By selling the call, you agree to sell your futures contract if the buyer exercises their option. This could force you to part with a position you might have preferred to hold for longer-term gains.

Why would a futures holder use a covered call?

If you’re already holding a futures contract, you may wonder why you’d opt to sell a covered call instead of simply holding the position. Here are some reasons this strategy makes sense:

• Income maximisation. Covered calls allow you to generate income even if the market isn’t moving significantly. If you anticipate stable or slightly rising prices, selling a call option can provide consistent returns through the premium collected.
• Partial hedging against losses. The premium acts as a hedge against small declines in the futures price. For instance, if your futures contract drops by USD 1 per unit, the premium offsets this loss, leaving your position relatively unchanged.
• Pre-determined exit point. By selecting a strike price you are comfortable with, you effectively set a price at which you’re willing to sell your futures contract. If the market rises above this level, you’ll still sell at a profit, with the premium adding to your gains.

Comparing covered calls to protective puts

To better understand the versatility of a covered call, let’s compare it to an alternative strategy: protective puts.

Covered calls

• Objective = Generate income by selling call options.
• Upside = Earn immediate cash flow from the premium and reduce minor downside risk.
• Downside = Limits potential profits if prices rise significantly.
• Best for = Slightly bullish to neutral market outlooks.

Protective puts

• Objective = Protect against major price drops by purchasing put options.
• Upside = Provides a safety net against large declines in the futures price.
• Downside = The cost of the put (the premium) reduces overall returns unless the market falls significantly.
• Best for = Bearish or uncertain market conditions.

Which strategy should you choose?

Your choice between a covered call and a protective put depends on your market outlook and goals:

• If you expect prices to remain stable or rise slightly, a covered call is ideal for generating extra income.
• If you are concerned about sharp declines, a protective put offers greater security.

By blending these strategies, you can adapt to different market scenarios and align with your risk tolerance and financial objectives.

Who should use covered calls?

Covered calls are a suitable option for investors and traders who:

• Already hold futures contracts and are open to selling them at a higher price.
• Want to generate additional income from their holdings.
• Are comfortable with capping their upside potential.

This strategy is particularly appealing for those who prefer steady, incremental gains over the unpredictability of high-risk trades.

A covered call is like finding a way to earn money from the assets you already own. Over time, the premiums collected from covered calls can build wealth in a controlled and sustainable way.