Covered Call
Covered Call
An options strategy where an investor owns 100 shares of stock and sells (writes) one call option against those shares to generate income from the premium received. The stock ownership "covers" the obligation to deliver shares if the call is exercised. This strategy produces premium income but caps upside potential at the strike price plus premium. Suitable for investors seeking income enhancement on existing stock positions with neutral to moderately bullish outlook.
An investor owns 500 shares of XYZ stock currently trading at $50. To generate income, they sell 5 call options with a $55 strike price for a $3 premium per share, receiving $1,500 total ($3 × 500 shares). If XYZ stays below $55, the calls expire worthless and the investor keeps both the stock and premium. If XYZ rises to $60, the calls will be exercised and the investor must sell at $55, missing the additional gain above $55 but still profiting from the $5 stock appreciation plus the $3 premium.
Students often confuse covered calls with naked calls (selling calls without owning the stock, which has unlimited risk). Covered calls have limited risk because the investor owns the underlying shares. Another common error is not recognizing that covered calls cap upside potential at the strike price, meaning the investor sacrifices gains above the strike. Many also confuse covered calls (bullish to neutral, income strategy) with protective puts (bearish protection, insurance strategy). Unlike protective puts which cost premium, covered calls generate premium income but provide minimal downside protection.
How This Is Tested
- Calculating breakeven, maximum gain, or maximum loss for covered call positions
- Determining suitability of covered calls based on client income needs and market outlook
- Understanding that covered calls generate income but cap upside potential
- Distinguishing covered calls (limited risk) from naked calls (unlimited risk)
- Recognizing when covered calls are inappropriate due to strong bullish expectations or need for unlimited upside
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Stock requirement for covered position | 100 shares per call option contract | Must own underlying shares to write covered calls; otherwise position is naked |
| Margin requirements | No additional margin required (stock serves as collateral) | Unlike naked calls which require substantial margin deposits |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Robert, a 58-year-old investor, owns 1,000 shares of ABC stock currently trading at $45 per share. He is moderately bullish on ABC over the next year but wants to generate additional income from his holdings. His primary investment objective is income, and he is willing to cap his upside potential in exchange for premium collection. Which strategy is most appropriate?
A is correct. Selling covered calls aligns perfectly with Robert's situation: he owns the underlying stock (1,000 shares = 10 option contracts), seeks income generation, is moderately bullish (not expecting dramatic upside), and explicitly accepts capped upside in exchange for premium income. The $50 strike allows appreciation from $45 to $50 while generating premium income. If the stock rises above $50, he profits from the $5 stock gain plus the premium received, achieving his income objective.
B (protective puts) costs premium rather than generating it, contradicting his income objective. This strategy protects against declines but requires paying premium upfront. C (naked calls) is highly inappropriate because he would be selling calls without owning sufficient shares to cover the obligation, creating unlimited risk exposure far beyond his 1,000-share position. D (buying calls) costs premium and is a speculation strategy for bullish investors expecting dramatic gains, not an income strategy. It would reduce current income by requiring premium payment.
The Series 65 exam tests your ability to match options strategies to client objectives and market outlooks. Covered calls are appropriate for income-oriented investors who own stock and are willing to cap upside potential. You must distinguish between income-generating strategies (covered calls, cash-secured puts) and cost-premium strategies (protective puts, long calls), and understand that covered positions have fundamentally different risk profiles than naked positions.
Which statement correctly describes the components of a covered call strategy?
B is correct. A covered call consists of two components: (1) owning 100 shares of the underlying stock, and (2) selling (writing) one call option on that same stock. The stock ownership "covers" the call obligation, meaning if the call is exercised, the investor can deliver the shares they already own.
A describes buying a call while owning stock, which is simply a long stock position plus a long call (bullish speculation), not a covered call strategy. C describes selling stock short plus selling a call, which creates a different risk profile and is not a covered call. D describes a naked (uncovered) call, which has unlimited risk because the seller does not own shares to deliver if exercised and would need to buy at market price.
The Series 65 exam tests your understanding of the precise structure of covered calls: own stock + sell call. This structure is critical because owning the stock limits risk to the stock price declining (same risk as owning stock outright) rather than the unlimited risk of naked call writing. Understanding what makes a position "covered" versus "naked" is fundamental to evaluating risk and suitability.
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Access Free BetaAn investor owns 300 shares of DEF stock purchased at $40 per share. The investor sells 3 covered call options with a $45 strike price for a $2 premium per share. What is the investor's maximum potential profit per share on this covered call position?
C is correct. Calculate maximum profit: (Strike Price - Purchase Price) + Premium Received = ($45 - $40) + $2 = $7 per share. Maximum profit occurs when the stock rises to or above the strike price ($45), at which point the calls will be exercised. The investor profits from the $5 stock appreciation ($40 to $45) plus the $2 premium collected, totaling $7 per share maximum gain.
A ($2) accounts only for the premium received but ignores the stock appreciation potential up to the strike price. B ($5) accounts only for stock appreciation from purchase price to strike price but forgets the premium income. D (unlimited) is incorrect because the call obligation caps gains at the strike price. Unlike owning stock alone (unlimited upside), the covered call caps maximum profit when the stock reaches the strike price.
The Series 65 exam tests your ability to calculate maximum profit for covered calls using the formula: (Strike - Purchase Price) + Premium. Understanding that upside is capped at the strike price plus premium is critical for evaluating whether covered calls are appropriate for clients expecting dramatic stock appreciation. This calculation helps compare covered call income against sacrificed upside potential.
All of the following statements about covered calls are accurate EXCEPT
B is correct (the EXCEPT answer). This statement is FALSE. Covered calls provide only minimal downside protection equal to the premium received. If the stock price declines significantly, the investor still bears the full loss on the stock position minus the small premium cushion. For example, if a stock drops from $50 to $30 (a $20 loss), a $2 premium only reduces the loss to $18, which is not "significant" protection. For substantial downside protection, investors should buy protective puts, not sell covered calls.
A is accurate: covered calls generate income through premium collection when selling the call option. B is accurate: upside is capped at strike price plus premium because the stock will be called away at the strike price if it rises above that level. D is accurate: the position is "covered" because the investor owns the underlying shares, which serve as collateral to fulfill the delivery obligation if the call is exercised.
The Series 65 exam tests your understanding that covered calls are primarily an income strategy, not a protection strategy. While the premium provides some downside cushion, it is minimal compared to the risk of stock ownership. Students often confuse covered calls (which generate income but provide minimal protection) with protective puts (which cost premium but provide substantial downside protection). Understanding this distinction is critical for recommending appropriate hedging strategies.
An investor owns 400 shares of GHI stock currently trading at $60. The investor has a neutral to slightly bullish outlook and wants to generate income. The investor is considering selling 4 covered call options. Which of the following are advantages of this covered call strategy?
1. Generates immediate income from premium collection
2. Provides unlimited upside potential if the stock rises dramatically
3. Reduces the breakeven point on the stock position
4. Allows the investor to profit from stock appreciation up to the strike price
B is correct. Statements 1, 3, and 4 are advantages of covered calls.
Statement 1 is TRUE: Selling call options generates immediate income from the premium received. The investor collects this premium upfront when writing the calls, providing immediate cash flow regardless of whether the calls are exercised.
Statement 2 is FALSE: Covered calls cap upside potential at the strike price, they do NOT provide unlimited upside. If the stock rises dramatically above the strike price, the investor misses those gains because the stock will be called away at the strike price. This is a key disadvantage, not an advantage.
Statement 3 is TRUE: The premium received reduces the breakeven point on the stock position. If the investor purchased at $60 and receives a $3 premium, the new breakeven is effectively $57 ($60 - $3). The premium provides a cushion against small declines.
Statement 4 is TRUE: The investor retains the right to profit from stock appreciation from the current price up to the strike price, plus keeps the premium. For example, with a $65 strike on stock at $60, the investor profits from the $5 appreciation if the stock reaches the strike.
The Series 65 exam tests your comprehensive understanding of covered call advantages and disadvantages. The key advantages are premium income, reduced breakeven, and retention of appreciation up to the strike. The key disadvantage is capped upside above the strike price. You must be able to evaluate whether the income benefit outweighs the sacrificed upside potential based on the client's market outlook and income needs. Covered calls are most suitable when the investor expects neutral to moderate gains, not dramatic appreciation.
💡 Memory Aid
Think of covered calls like renting out your house while you still own it: You collect rent (premium) for giving someone the right to buy it (call option), but if they exercise that right at the agreed price (strike), you must sell. You profit from appreciation up to the sale price plus rent, but sacrifice gains above that. The house you own "covers" your obligation to deliver, unlike promising to sell a house you don't own (naked call = unlimited risk).
Related Concepts
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Where This Appears on the Exam
This term is tested in the following Series 65 exam topics: