• Long 100 shares.
• Short 1 out-of-the-money call.

<Covered call risk graph retrieved from OptionsPlay>

A covered call is long 100 shares of a stock and also short a call. It can be long any security (which has options) and short a call on it, but it is often easier to think about in terms of stocks. Generally, a trader will short an out-of-the-money call. 

As a warning, this strategy has potentially severe loss to the downside as compared to a call spread. The short call offers only a limited amount of protection, and once that protection is spent, then the loss from a crash down in the price would be equally damaging to that of being long 100 shares.

Intermediate: Controlling the Risk

The bottom line is that there is less capital at risk in a [covered] call position than from simply holding 100 shares. 

Given that this is a risk-reduction strategy, it is normal for IRAs to allow it, and at the lowest possible level of trading permissions. 

However, the presence of the bullish deltas from the long underlying portion of the strategy, and how that overwhelms the short call delta, means that then there is severe risk is to the downside: The short call can only protect the underlying security to the extent that it burns up the max profit from its credit. 

Advanced: Strategic Considerations

The main drawback of a covered call strategy would be surrendering potentially unlimited gains from an outsized move to the upside, and that this would have only been in exchange for small income from the short call. 

As a point of logistics, if the short call gets assigned then you will lose those 100 shares. However, you can simply buy them back and then short another call if you like.

Either way, if a trader has already accepted the risk of being long 100 shares, then one way to leg in and out of covered calls is to short a call when the Call Wall is touched from underneath. By doing so, the trader legs into the short call into strength. If the 100 shares had been climbing without the short call until that point, then this locks in some profit and reduces some risk, while also collecting some time decay from the short call.
In a scenario where the short call breaches the money and becomes ITM, one reasonable approach is to close the short call for a loss, and then sell some of the shares. This locks in a net profit and removes a balanced amount of deltas from each side of the trade. And with fewer shares, one would have less risk and also some continued upside exposure, partially financed by house money from the profit taking. 

Alternatively, you can close the entire position for a profit since, as a trade, it would be near max profit. However if viewing the underlying with a long-term outlook, it could make more sense simply to reduce the size of the position while trimming the short call. The way that might play out is to add more shares in the next dip and then to write another call on the next sharp rally.

If the short call premium is too low, then it might not be worth capping the upside potential of the underlying, and simply going long the shares without a short call. This is why some traders will use a minimum price filter for short calls, meaning that they would not consider writing a call unless the premium is above a certain amount. This filter can be a minimum percentage of the premium in relation to the underlying or it can be based on a minimum fixed amount, such as 50 cents or a dollar. If only collecting about 30 cents or less, then there would hardly be anything left after commissions, the bid/ask spread, and exiting at about a 50% profit target rather than waiting for expiration. 

More premium could be found by looking to higher durations (DTE) but some products simply do not work well with covered calls because they do not have a wide enough implied range. This means you might only get decent premium one strike out and then after that almost nothing. This is often the case on securities that have a high-yield such as bond ETFs or dividend stocks.

Expert: Tactics and Synthetics

It is ideal to write options in general when IV (implied volatility) is elevated. For this approach, exploring the term structure (comparison of IV to time) for monthly or particular weekly options with the highest IV can be used as an edge for selecting DTE. However, this assessment of IV% across different dates is only accurate if factoring in a calculation of forward implied volatility. 

Another tactic is to hold the underlying and trade short calls as a cash flow enhancement. For example, hold the underlying if bullish but then write calls into strength on sharp rallies. This usually has the added benefit of capturing swelling call skew because of call buyers piling on out of FOMO (fear of missing out) during the uptrend. From here, profit can be captured after the short call hits about 50% max profit. In this way, one can hold the underlying for some stability, and then trade the short calls on top.

The price of the short call would drop from decreases in price, IV, or time. However, if the call becomes ITM, then time and IV decay are not a call overwriter's friend because the short call would be pricing in a 100-delta outcome and increasing the cost of the premium. The forces at work here are how charm and vanna help the holder of an OTM short option if IV and time are decreasing. Conversely, charm (the effect of time on delta) and vanna (the effect of implied volatility on delta) hurt the holder of an ITM short option if IV and time are decreasing. 

A covered call with 100 shares long and short a call at 20 delta has the instantaneous PnL of being long 80 shares. Synthetically, it would also have the same max profit, uncapped risk, and Greek dynamics as being short an 80-delta put (at the same strike). 

This synthetic equivalent of a short put would predictably be less liquid and with a wider bid/ask spread, meaning more slippage, but like the covered call it would have capped risk to the upside and an unlimited downside. Via put-call parity, the Greek measurements and nonlinear payout structure would be nearly equivalent. However, unlike shorting a put, a covered call allows the tactical granularity to trim or add shares, as well as to trade the short calls.

bid/ask spread: The bid is the highest price buyers are willing to pay for a security, and the ask is the lowest price that sellers are willing to sell a security. The difference between these prices is the bid/ask spread. Highly liquid securities (having many active buyers and sellers) such as SPY usually have a bid/ask spread of only one cent, even in the premarket and postmarket. Examining the width of the bid/ask spread can be a more reliable way to gauge option liquidity than volume or OI.

bullish: A trade is bullish if it would profit from an increase in the underlying (e.g. stock or future) price. Likewise, a trade thesis is bullish if it is expecting the underlying to increase.

Call Wall: The Call Wall is the strike with the largest net call gamma. This shows us what the top of the probable trading range is (the upper bound).

defined risk: In an option strategy, if risk is defined then it is structured so that it has a max loss (capped total loss on a trade) rather than potentially unlimited loss.

delta: A first-order Greek that measures the sensitivity of an option's price to directional movement in the underlying security. Factoring out nonlinear dynamics, the instantaneous value of one delta is worth one share of a stock. This means that if the option on a stock is 40 delta, such as a 40 delta long call or a 40 delta short put, then instantaneously it has the same profit/loss dynamics of being long 40 shares. 

DTE (days to expiration): Every option has a DTE figure which counts down how many days are remaining in the contract. It depends on the broker, but this is generally posted right at the top of each option chain. The DTE of an option is always one of the most important components of setting up an option strategy.

forward implied volatility: Forward IV is the difference in IV that can be derived from two points on the term structure. It tells us how much IV needs to change from one date to the next after being adjusted for DTE (days to expiration). Forward IV is calculated as the square root of the difference in variance divided by the difference in time, with time (T) being the DTE. This can be expressed as: (T₂*σ²  - T₁*σ²)  /  ( T₂ - T₁). The DTE is multiplied against the IV% to weight it.

Greeks: An option Greek is a type of risk metric that compares the change in one thing to a change in the other. A first-order Greek is the change in one thing compared to a change in the price of an option. The major first-order Greeks are delta (sensitivity to direction), vega (sensitivity to implied volatility), and theta (sensitivity to time decay). 

instantaneous PnL: The real-time profit or loss associated with an options position. On the risk chart for an option, this is the smooth and curved line. What instantaneous PnL shows is how much profit or loss would be available if the position was closed immediately.

ITM (in the money): An option is in-the-money if it would still have some [intrinsic] value if the option expired with the underlying price where it currently is. Being in the money is entirely about the strike price beating the underlying price. ITM options cost more than options at or out of the money; they also have less extrinsic value. Additionally, ITM options have more deltas (immediate directional risk).

IV (implied volatility): The expected percentage range over a year with 68.3% confidence. This is based on options pricing at one standard deviation. Long options benefit from increases in implied volatility and short options benefit from decreases in implied volatility. In general, when implied volatility increases it means that the expected percentage range is getting larger. When implied volatility is applied to lengths of time other than one year, then this is called the expected move.

leg in: Legging into a strategy is when one part of a spread is put on before the second or additional parts of the trade within a strategic option structure. For example, after some success, a long call can leg into a debit call vertical by shorting a call into strength. This would lock in some gains and reduce risk on that long call, but there would be some leg risk in order to get there.

leg out: Legging out of a strategy is when one part of an options spread is closed before the other part(s).  For example, if one has a debit put vertical (long put and a short put at a lower strike) which loses money on a large move up in the market, then the short put can be closed for a profit. This would partially subsidize the long put and give it a chance to run without a spread if the market crashes back down. As an important point on risk management, it is always safer to leg out by closing a short option—rather than a long option—because this way the risk still remains defined (limited).

nonlinear payout structure: This term can be used to describe the amplified or diminishing return characteristics for an options trade as the price of the underlying security goes up or down, or if implied volatility or another Greek influence goes up or down. When buying or selling a security directly, the returns are linear when the underlying moves in either direction (1:1). 

put-call parity: In options, put-call parity is a property of theoretical options pricing models which establishes how calls can have equivalent profit and loss dynamics to puts (as well as Greek dynamics). The logical equivalence of different option structures via put-call parity is known as synthetics. For a long call to be a synthetic match with a long put on the same strike, the trader also needs to be short 100 shares. And for a long put to be a match with a long call on the same strike, the trader needs to be short 100 shares. Being on the same strike is key for these matches. With a short call, it is a logical match with a short put if the trader is long 100 shares. And with a short put, it is a match with a short call if the trader is short 100 shares. For vertical or horizontal spreads, shares do not need to be traded for synthetic equivalence; the rule is simply that the same strikes must be used and long is swapped for long and short is swapped for short. For example, a credit put vertical logically becomes a debit call vertical by lining up and swapping the long put for a long call and the short put for a short call.

security: Any investment product that can be traded on an exchange, such as but not limited to stocks, futures, ETFs, options, bonds, mutual funds, and treasuries. 

short call: To be short (sell to open and hold) a call. Unless otherwise hedged, the owner of the short call has unlimited risk and only limited potential gains, which makes this an extremely dangerous strategy in isolation. If left to expire, a short call will achieve max profit if the price ends up underneath the strike price. Shorting a call is a way to express a thesis that one is “not bullish” such as what might be justifiably the case if testing a Call Wall from underneath; being “not bullish” is different than being bearish. For a short call to be profitable, the underlying security must underperform the premium placed on that call by the options market. In other words, a short call profits when the underlying security fails to beat the options market. To be closed early for a profit, there needs to be a decrease in implied volatility or the underlying must have increased less than the options market has priced in for that specific period of time. All short calls have short gamma and short vega but long theta. Short options also come with obligations instead of rights, which means that, at any time, shares can be assigned (100 short shares for each contract); assignment usually only happens when in-the-money and near expiration). Synthetically, a short call becomes logically equivalent to a short put if the trader is also long 100 shares.

skew: Volatility skew is the difference between implied volatility amounts of different options strikes on the same date. Implied volatility is the expected percentage range over one year–based on option prices–with 68.3% confidence. Skew is one of the main edges to look for in an options trade, especially on vertical spreads (all options are on the same date). Sometimes it is a penalty dragging down a good trade, but it is nonetheless important to understand the extent of how much it can challenge a trade if knowingly accepting to take the opposite side of a skew advantage.

slippage: Losses that occur from trading as a result of commissions and differences in the bid/ask spread. 

synthetics: In options, synthetics are different structures that have the same logical dynamics, including the same max loss, max profit, chance of winning, and option Greeks. Synthetics are possible because options have the property of put-call parity. For spreads, long puts can be swapped for long calls and short puts can be swapped for short calls (and vice versa) in a way that creates synthetic matches without the need of adjusting deltas with shares. On single-leg options, however, puts and calls can be swapped in the same way, but require directionally-offsetting positions in the underlying security (such as a certain amount of shares).

term structure: A two dimensional graph of implied volatility (y-axis) compared to time (x-axis). IV (Implied volatility) is the expected percentage range over the next year—based on option prices—with 68.3% confidence. One important dynamic of term structure is that it is not simply enough to compare different IV% amounts side by side for term structure edge. Rather, different IV% amounts must first undergo a calculation for forward IV. After this calculation, if one IV% is higher than the other, then there can be a term structure edge in buying the lower IV% and selling the higher IV%.

writing: We say “write” when a trader sells an option to open a new position. Simply saying “to sell” an option is unclear, as that could mean either selling-to-close or selling-to-open a new position. The most common example of writing is the covered call strategy, which is buying 100 shares in a stock and then selling-to-open a short call on that same stock. In general, writing is to accept an obligation, and there is time-decay income in exchange for that risk (as well as the risk of assignment which is being delivered shares that can create a jump in directional risk).