Covered Call
The problem with selling a naked call is that it has unlimited exposure to
upside risk. Because of this, many traders simply avoid trading naked calls.
A more common, and some would argue safer, method of selling calls is to
sell them covered.
A covered call is when calls are sold and stock is purchased on a share-
for-share basis to cover the unlimited upside risk of the call. For each call
that is sold, 100 shares of the underlying security are bought. Because of the
addition of stock to this strategy, covered calls are traded with a different
motivation than naked calls.
There are clearly many similarities between these two strategies. The
main goal for both is to harvest the premium of the call. The theta for the
call is the same with or without the stock component. The gamma and vega
for the two strategies are the same as well. The only difference is the stock.
When stock is added to an option position, the net delta of the position is
the only thing affected. Stock has a delta of one, and all its other greeks are
zero.
The pivotal point for both positions is the strike price. That’s the point the
trader wants the stock to be above or below at expiration. With the naked
call, the maximum payout is reaped if the stock is below the strike at
expiration, and there is unlimited risk above the strike. With the covered
call, the maximum payout is reaped if the stock is above the strike at
expiration. If the stock is below the strike at expiration, the risk is
substantial—the stock can potentially go to zero.
Putting It on
There are a few important considerations with the covered call, both when
putting on, or entering, the position and when taking off, or exiting, the
trade. The risk/reward implications of implied volatility are important in the
trade-planning process. Do I want to get paid more to assume more
potential risk? More speculative traders like the higher premiums. More
conservative (investment-oriented) covered-call sellers like the low implied
risk of low-IV calls. Ultimately, a main focus of a covered call is the option