Want to generate extra income from your stock holdings or maximize your returns when selling shares? The covered call strategy could be just what you're looking for.

Imagine you own 100 shares of XYZ at $90. The price has risen to $108, and you plan to sell at $110. Instead of simply waiting for the price to reach $110, you can sell a covered call option to another investor, expiring in six weeks at the $110 strike price.

This means you've agreed to potentially sell your XYZ shares to this investor for $110 anytime before the expiration date. In exchange, the investor pays you a premium for this right. This premium is the extra income you receive for offering your shares.

It's important to understand: The investor has the right, but not the obligation, to buy your shares. If the price doesn't go above $110, they likely won't exercise their option, and you'll keep the premium and your shares.

Welcome to the world of covered calls!

The covered call is constructed when an investor buys at least 100 shares of stock and then sells a call option contract against the shares that he or she owns.

Note, in most scenarios the stock is usually bought first and when the share price has risen the investor will then sell the covered call. You can place both orders at the same time.

In our XYZ example, we bought 100 shares at $90 and sold the $110 call option later when the share price rose substantially.

The covered call strategy will always be established at a net debit. The major cost is buying the shares but some of this cost is reduced by selling the covered call. Overall, the trade is established as a debit.

Look at the call option quote for Apple:

To establish a covered call with AAPL, imagine that we bought 100 Shares of Apple at $90 several months previous. The share price has risen substantially to $108 and we are getting ready to sell at $110. Instead of waiting for the share price to rise, we decide to sell 1 call option contract of the Jan 20th $110 call option for $2.61 (Bid) or $261 total (because 1 contract controls 100 shares). The result is us holding 1 covered call on AAPL for the $110 strike price.

The net debit or cost is the price paid for the shares ($90) minus the income from the covered call ($2.61) which equals $87.39.

This is one of the real benefits of the covered call. The initial cost of buying the stock is being reduced by the sale of the call. Let’s start comparing the two strategies:

As you can see, by selling the call we have reduced the net purchase cost of the stock.

The covered call is a mildly bullish or neutral strategy. By employing this strategy, we are only mildly bullish on Apple, as we expect to sell the stock at the call option's $110 strike price. An investor with a more bullish outlook will simply own the stock.

The maximum upside profit for our Apple covered call is said to be ‘limited’ to the difference between the strike price ($110) and the purchase price of the stock ($90) plus the credit received ($2.61) for selling the call. The max profit occurs when the share price trades at or above the $110 short call strike price at expiry.

Maximum Profit = Short Call Strike Price minus Purchase Price Stock plus Credit received AAPL example:

Max Profit = $110 (Short Call Strike) minus $90 (Purchase price Stock) plus $2.61 (Credit from sale of $110 Call) = $22.61 per share or $2,261 total.

Let’s do a quick comparison of our profit potential if we simply bought 100 shares of the AAPL stock at $90 and if the share price rose to $110. The profit would be $20 per share or $2,000 total.

When we compare the max profit of the covered call strategy versus simply buying the stock, we can see the power of the covered call strategy. We have made more profit for the same scenario.

However, one must bear in mind that the upside potential is capped with the covered call strategy. In our AAPL example, the max profit is $2,261. The upside potential for just owning the stock is not capped, as the share price continues to rise so do the profits.

This is a major trade-off that you must consider for the covered call.

The counter argument for the covered call is that although there is more potential upside in simply owning the stock, we will not be in the stock to benefit from it. This is because we intended selling at $110 regardless.

The lesson here is to ensure that you pick a strike price at which you are happy to sell your shares at.

The maximum loss for the covered call strategy is said to be ‘unlimited’. As the share price of Apple falls below the break-even price, losses continue to accumulate. Theoretically, share prices can fall to zero, therefore losses can be substantial. The maximum loss is limited to the cost of the stock minus the premium received for selling the covered call.

Again, the covered call compares favorably against buying the stock outright.

The break-even price for the covered call is equal to the purchase price of the stock minus the income received for selling the call option.

Looking at our Apple example:Break-even price = $90 (purchase price shares) minus $2.61 (income from calls) = $87.39

This is another advantage of the covered call over simply buying the stock. You can see from the above that the share price can fall further with the covered call before we start to make a loss.

Partial Profit occurs if the share price at expiry is between the breakeven-price and max profit. In our example with Apple, partial profit occurs at expiry if Apple trades between $87.39 and $110.

Before expiration, an investor can take a profit or cut a loss by buying the call option if it has market value which will be done at a net debit. The investor can also decide to then sell the stock. Profit or loss would simply be the net difference between the debit initially paid for the stock and the sale of the call option and the net credit received for selling the stock and buying back the call option.

Here is an example of a P&L table for the AAPL covered call. Remember we bought 100 shares of the stock for $90 and we sold the $110 call for $2.61.

An increase in volatility has a negative effect on the covered call. As volatility increases the time value of the call option increases. Therefore, if an investor changed their mind and wanted to buy back the call option, the time value element will be more expensive to repurchase.

Theta is the rate of decay in the time value of an option. Theta has a positive effect on the covered call. Because you sold the call option, theta is working to your advantage. As each day passes to expiry the reduction in time value of the option is working to your advantage.

Look at the option quote for Apple again:

You can see from the quote that the $110 call has a theta value of -0.030. What does this mean? It means that the value of the $110 call will erode by $0.03 per share or $3 total per day between now and expiry. Because we sold the call option, this is working to our advantage. If all things being equal and conditions do not change, we could buy back the call that we sold at a cheaper price than what we paid for it because of time decay.

At Share Navigator, we love selling time premium when implied volatility is high.

Some covered call strategies can be considered more bullish than others. The degree of bullishness depends primarily on the strike price of the short call, which determines how high the underlying stock (or index) needs to increase for maximum profit to be realized at expiration.

Assignment on any Equity option or American-style index option can, by contract terms, occur at any time before expiration, although this generally occurs when the option is in-the-money.

The action you take at expiry will depend on where the share price is trading at:

For those who want to own shares and generate additional monthly income or maximise the potential sale of stock, it is excellent. For the novice option trader, covered calls are a great start to learning about options.

However, as you become more experienced you will find less risky ways of achieving the same profit potential using other option strategies.

Time for you to apply your knowledge.

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