Covered Call Writing for Equity Options
The covered call is the most widely used options strategy and one of the most frequently tested on the Series 7. It combines a stock position you already own with a short call to generate income.
Strategy Construction
- A covered call (also called a buy-write) consists of owning 100 shares of the underlying stock and selling (writing) one call option against those shares
- The position is "covered" because the writer already owns the stock needed for delivery if the call is exercised
- The writer collects the premium upfront, which provides income and a limited downside cushion
Key point: The word "covered" means the obligation to deliver shares is backed by actual stock ownership. If you sell a call without owning the stock, that is a naked (uncovered) call, a completely different risk profile.
Profit, Loss, and Break-Even
| Metric | Formula |
|---|---|
| Maximum gain | (Strike price - stock purchase price) + premium received |
| Maximum loss | Stock purchase price - premium received (stock drops to zero) |
| Break-even | Stock purchase price - premium received |
- Maximum gain is capped. If the stock rises above the strike, the call is exercised and shares are called away at the strike price. The writer keeps the premium but misses any upside beyond the strike.
- Maximum loss occurs if the stock falls to zero. The premium received only partially offsets the decline.
- The covered call writer's break-even is lower than the stock purchase price by the amount of premium received. The premium creates a small cushion.
Example: Buy stock at $50, sell a 55 call for $3
| Metric | Calculation | Result |
|---|---|---|
| Max gain | ($55 - $50) + $3 | $8 per share |
| Max loss | $50 - $3 | $47 per share |
| Break-even | $50 - $3 | $47 |
Think of it this way: You bought the stock at $50 and collected $3 in premium, so your effective cost is $47. If the stock drops to $47, you break even because the premium absorbed the loss. Above $55, though, your shares get called away, so the most you can ever make is the $5 stock gain plus the $3 premium ($8 total).
Exam Tip: Gotchas
- Maximum gain is capped at the strike price (plus premium), no matter how high the stock goes.
- The break-even is below the stock purchase price because the premium lowers it.
When to Use a Covered Call
- Income generation: The primary motivation is to earn premium income on a stock position, especially in flat or slightly bullish markets
- Partial hedging: The premium provides a small cushion against a decline in the stock price; this is NOT a full hedge
- Willingness to sell: The writer must be willing to sell shares at the strike price if exercised
Market outlook: Neutral to slightly bullish. If you were strongly bullish, you would not want to cap your upside by selling a call.
Exam Tip: Gotchas
- Selling a covered call is NOT a full hedge. It only provides partial downside protection equal to the premium received. If the exam asks for the "best protection" or a "full hedge" for a long stock position, the answer is buying a put (protective put), not selling a call.
Assignment Risk
- If the stock price rises above the strike, the call buyer is likely to exercise, and the covered writer must deliver shares at the strike price
- Early assignment is most likely just before an ex-dividend date when the call is in-the-money and the remaining time value is less than the upcoming dividend
- American-style equity options can be exercised at any time before expiration
Exam Tip: Gotchas
- Early assignment risk increases near ex-dividend dates. When the call is in-the-money and remaining time value is less than the upcoming dividend, the call buyer is likely to exercise early.