OPTIONS TRADING

Covered calls are a common options strategy in Canada that allows investors to generate additional income from stocks they already own. By selling call options against existing shares, investors could collect premiums while managing potential upside and understanding the associated risks. This article explains the basics, outlines key considerations, and provides an illustrative example of how covered calls work.

This content is intended for educational purposes only and is not a recommendation or financial advice.

What is a Covered Call?

A covered call is an options position in which an investor simultaneously holds long shares of a stock or ETF and sells a call option on those same shares. At a basic level, the approach combines ownership of the underlying asset with the obligation to deliver it if the option is assigned.

Position components include:

• Underlying shares: The stock or ETF that is held and covered by the call option.
• Call option: A contract granting the buyer the right, but not the obligation, to purchase the underlying shares at a specified strike price by the expiration date. As a seller, you have the obligation to sell the underlying shares at the specified strike price typically before expiry.
• Premium: The income received by the seller (writer) of the call, which compensates for the potential obligation to sell the shares.
• Coverage alignment: Standard options contracts typically represent 100 shares per contract.

Rights and obligations:

• Option holder (buyer): The buyer has the right to buy shares at the strike price before or at expiration, but is not obligated to do so.
• Option writer (seller): The seller receives the premium and is obligated to sell the shares if the option is assigned.

High-level outcomes at expiration:

• In the money (ITM): Stock price exceeds the strike price; the option might be exercised, and shares are sold at the strike price.
• Out of the money (OTM): Stock price remains below the strike price; the option expires worthless, and the writer retains the shares and premium.

Overall, a covered call is a position that combines share ownership with a short call, providing defined obligations and potential outcomes. The premium serves as compensation and shapes the payoff profile, while the core exposure remains tied to the underlying shares.

How a Covered Call Works

A covered call combines owning shares with selling a call option on those shares. This creates a position with a specific payoff profile while still keeping exposure to the underlying stock.

Payoff Dynamics

• Upside capped above strike: Profits on the stock are limited to the strike price plus the premium collected. Any gains above the strike are not realized if the option is exercised.
• Downside retains shares exposure: Losses on the stock still occur if the price drops, though the premium provides a small buffer.

Option Outcomes at Expiration

• ITM: Stock price is above the strike, the option might be exercised, and shares are sold at the strike price.
• ATM: Stock price is near the strike, and exercise is possible depending on small price movements.
• OTM: Stock price is below the strike, the option expires worthless, and the shares and premium are kept.

Assignment and Exercise

• Assignment: Assignment happens when the option buyer decides to exercise the contract, requiring the seller to deliver shares at the strike price.
• Exercise: The process by which the option holder enforces their right to buy the shares. Each option contract usually covers 100 shares, matching the number of shares held.

Dividend and Ex-Dividend Timing

The timing of dividends could sometimes influence whether an in-the-money option is exercised early, though this is only one of many factors.

In summary, a covered call provides income from the premium, limits upside above the strike, and keeps exposure to the underlying stock. Understanding ITM, ATM, and OTM scenarios, along with how assignment works, helps clarify the mechanics of this position in a simple, educational way.

Key Terms

• Covered call: An options position that combines ownership of the underlying shares with the sale of a call option on those same shares. The shares "cover" the obligation created by the call.
• Strike price: The predetermined price at which the call option holder might buy the underlying shares if the option is exercised.
• Expiration date: The last day on which an option contract is valid. After this date, the option expires and could no longer be exercised.
• Premium: The amount paid by the option buyer and received by the option seller. It represents the price of the option contract.
• Contract multiplier: The number of shares represented by one option contract. In standard equity options, one contract typically represents 100 shares.
• In the money, at the money, and out of the money: For call options, ITM means the stock price is above the strike price, ATM means it is near the strike, and OTM means it is below the strike.
• Intrinsic value (call): The amount by which a call option is in-the-money, calculated as the stock price minus the strike price, if positive.
• Extrinsic value: The portion of an option's premium that reflects the time remaining until expiration and the potential for price movement.
• Assignment: The process by which a call option seller is required to deliver shares when the option buyer exercises the contract.
• Exercise: The act of the option holder using the right granted by the contract to buy the underlying shares at the strike price.
• Ex-dividend date: The date on which a stock begins trading without the right to receive the upcoming dividend.
• Bid/ask spread: The difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask).
• Open interest: The total number of outstanding option contracts that have not been closed or exercised.
• Volume: The number of option contracts traded during a given period, usually shown daily.
• Options chain (calls panel): A table displaying available call options for a security, including strike prices, expiries, premiums, and trading activity.
• Covered ratio: The proportion of shares held relative to the number of options contracts sold, ensuring full coverage of obligations.
• Implied volatility (IV): A measure of the market's forecast of a stock's potential price movement, which influences option premiums.
• Delta: A metric showing how much an option's price is expected to change for a $1 move in the underlying stock.
• Theta: The measure of an option's time decay, representing how much value the option loses as it approaches expiration.
• Bid price: The highest price a buyer is willing to pay for an option.
• Ask price: The lowest price a seller is willing to accept for an option.
• Closing order: A trade that removes an existing option position, either by buying back a sold call or selling a held call.
• Exercise style: The type of option exercise allowed, typically American (could exercise anytime before expiration) or European (could exercise only at expiration).
• Settlement: The process of delivering shares or cash when an option is exercised or expires.

Combined Payoff (Illustrative)

Here's an illustrative example using simple numbers to show how owning a stock and selling a call work together at expiration.

Covered Call at Expiration

The table below shows how a covered call could behave at expiration when the stock price ends at different levels.

Assumptions for this example:

• 100 shares bought at $50.
• One call sold with a $55 strike.
• Premium received is $2 per share ($200 total).

This is illustrative only. The values shown are examples and not indicative of real outcomes.

Understanding the Table

• When the stock finishes below the strike: The call expires worthless. The result mainly reflects the stock's gain or loss, with the premium helping to soften the outcome.
• Near the strike price: This is where the combined position often shows its highest payoff, capturing both the stock's move up to the strike and the full premium.
• Above the strike: Once the stock moves past $55, the combined profit no longer increases. Extra stock gains are offset by losses on the short call.
• Assignment at expiration: When the option is in the money, shares are typically sold at the strike price, which explains why profits flatten out above that level.
• Opportunity cost: Any price increase beyond the strike represents upside that is given up in exchange for the premium received upfront.

How to Set Up a Covered Call

The steps below outline, at a high-level, how a covered call is typically set up on an options-enabled trading platform.

1. Confirm the share position:
   • Verify that the underlying shares are already held in the account.
   • Check coverage alignment between shares and contracts, noting that standard equity options usually represent 100 shares per contract.
   • Ensure the number of shares entered does not exceed the number of shares available to cover the obligation.
2. Locate call options on the options chain:
   • Open the options chain for the selected stock or ETF and navigate to the calls panel.
   • Review available expiration dates and strike prices shown in the chain.
   • Observe quoted premiums, bid/ask spreads, volume, and open interest as part of normal contract selection.
3. Enter the order details:
   • Select the desired expiration date and strike price for the call option.
   • Set the order quantity based on the covered share count.
   • Choose an order type (e.g., limit or market) according to standard platform functionality.
   • Review the order summary carefully before submitting.
4. Order handling and position monitoring:
   • After submission, orders might fill immediately, partially fill, remain open, or be cancelled depending on market conditions.
   • Order status could be checked in the platform's activity or orders section.
   • Once filled, the covered call appears as a combined position consisting of shares held and a short call, which could be monitored through to expiration or earlier closure.
5. Learning resources and navigation:
   • Many Canadian trading platforms provide first-party educational guides, videos, and help articles explaining options trading workflows and order entry screens.
   • Platform-specific tutorials could be used to understand where to find the options chain, how orders are displayed, and how option positions are tracked over time.

Registered vs. Non-Registered Accounts (Canada)

In Canada, covered calls might be available in both registered and non-registered accounts, but how they are supported could differ by account type and by brokerage. The notes below provide a high-level, educational overview of common operational differences.

Registered Accounts

• Some registered plans, such as TFSAs and RRSPs, generally allow covered calls when the option is fully backed by the underlying shares.
• Option activity in these accounts is typically limited to simpler positions, with additional restrictions compared to non-registered accounts.
• Trading options often require specific account permissions or approvals, which are set by each brokerage.
• Position details, trade confirmations, and option activity are usually accessible through standard platform areas such as account activity, statements, or positions.

Non-Registered Accounts

• Non-registered (taxable) accounts commonly support a broader range of option activity, including covered calls, subject to firm-specific rules and approvals.
• Reporting for these accounts typically includes transaction history and position details that could be viewed through the platform's reporting or statements sections.
• Operational features, such as margin availability and option permissions, vary by firm and are defined in account documentation.

Important Notes

• Eligibility, approvals, and available option features are determined by each brokerage and might change over time.
• Platform-specific help pages and platform documentation are the most reliable sources for confirming what is supported in each account type and where related records could be found.

Risks and Considerations

Covered calls are straightforward in structure, but they still involve trade-offs and day-to-day considerations. The points below explain the main ones.

• Upside is capped above the strike price: If the stock rises well above the strike price, gains stop increasing beyond that level. The trade-off is giving up some potential upside in exchange for the option premium received.
• Assignment could happen: When a call option is in the money, the shares might be sold at the strike price. This is more likely as expiration approaches or around certain dates, such as the ex-dividend date, though outcomes could vary.
• Liquidity and execution matter: Some options trade more actively than others. Wider bid/ask spreads or lower trading volume could affect pricing, lead to partial fills, or make it harder to exit a position at a specific price.
• Corporate actions could change contracts: Events like stock splits, mergers, or special dividends might result in adjustments to option contracts. These changes are handled by the clearing process and could affect contract terms.
• Ongoing monitoring is part of the process: Covered calls typically involve tracking expiration dates, option status, and the underlying shares. Most platforms display this information in positions or account activity views.