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Covered Call vs. Regular Call: An Overview
A call option is a financial contract that gives the buyer the right (but not the obligation) to buy an asset at a predetermined price by a predetermined date. Calls are used to trade different assets, including stocks, bonds, commodities, and currencies among others, If the buyer chooses to exercise the option, the contract holder must sell the underlying asset.
There are different call strategies, including covered and regular calls. Both are complex trading and rely on price movements in an underlying asset. But they are inherently different. The seller in a covered call tends to hold a neutral or bullish position, expecting an increase or a minor drop in the underlying asset’s price—which they don’t own. Regular calls, on the other hand, are bearish and more risky because the contract holder doesn’t own the underlying asset.
Key Takeaways
- A call option is used to create multiple strategies like a covered call or a regular call option.
- The seller of a covered call owns the underlying asset while the seller of a regular call doesn’t.
- A covered call takes a neutral to bullish view and comes with risk if the price of the asset plummets.
- A regular call assumes a neutral to bearish view with the risk of loss if the asset’s price increases.
- Covered call contract owners earn a premium from the option and income from the asset while owners of a regular call only earn a premium from the option.
Covered Call
A covered call is a complex financial contract that involves speculating on the price of an underlying asset. In this option strategy, the holder of the contract owns the underlying asset, such as a stock, bond, commodity, or other financial security. It gives the buyer the right (but not the obligation) to exercise the option, which means they can buy the underlying asset at a predetermined price by the contract’s expiry date.
In a covered call, the contract holder sells a call option that is covered by a long position in the asset. This means the contract holder has a neutral to bullish view of the market. As such, the trader expects a moderate rise in the asset’s price with little to no volatility. The seller risks losing money if the price of the underlying asset plummets.
This strategy provides downside protection on the stock (or underlying asset) The option is not exercised unless the price of the asset increases, allowing the contract holder to generate a premium on the call option as well as potential income from the asset.
The strike price is a key component of an options strategy. The strike price is the price at which the underlying security can be either bought or sold once exercised.
Regular Call
Just like a covered call, a regular call is an option wherein the buyer has the right (but not the obligation) to buy the underlying asset at a specific price by the expiration date. But in this case, the seller of the contract doesn’t own the asset. This is why a regular call is also called a naked call.
The seller creates a short position in the asset, which is why this type of option is also called a short call when they are exercised. An investor in a naked call position takes a neutral to bearish position in the short term. As such, they believe the price of the underlying asset will drop or will experience a minor increase.
Unlike a covered call strategy, this strategy’s upside is just the premium received. They can be very risky with the potential for major losses, especially when there is a major increase in the asset’s price before the contract’s expiration date. Since the seller doesn’t own but promises to deliver the asset if the buyer chooses to exercise the option, they must purchase the asset to meet their obligation.
Key Differences
| Covered Call vs. Regular Call: Key Differences | ||
|---|---|---|
| Covered Call | Regular Call | |
| Ownership of Asset | The contract holder owns the underlying asset | The contract holder doesn’t own the underlying asset |
| Position in the Asset | Covered by a long position in the asset | Covered by a short position in the asset |
| Market View | Neutral to bullish view of the market | Neutral to bearish view of the market |
| Risk | Risk of loss if the price of the underlying asset plummets | Risk of loss if the price of the underlying asset increases |
| At Expiration | Can deliver the underlying asset if the buyer exercises the option | Must purchase the underlying asset if the buyer exercises the option |
| Earnings | Call premium and potential income from the asset | Call premium only |
Example of Covered Call vs. Regular Call
Suppose an investor is long 500 shares of Company DEF’s stock at $8 per share. The stock is trading at $10 per share, and the investor is worried about a potential fall in price within six months. The investor can sell five call options against their long stock position. Suppose they sell five DEF call options with a strike price of $15 and an expiration date of six months.
If the stock price stays below the strike price, they would keep all the premiums on the call options because they would be worthless. They would still profit if the shares rise above $15 because they are long from $8. Since the investor is short call options, they are obligated to deliver shares at the strike price on or by the expiration date, if the buyer of the call exercises their right.
On the other hand, suppose another investor sells a call option on DEF with a strike price of $15, expiring next week. They are in a naked call position. Theoretically, they have unlimited downside potential. Their reward for taking on this risk is just the premium they received.
What Are the Downsides to Covered Calls?
Downsides occur with any type of investment. With covered calls, there is a chance of loss if the price of the underlying asset plummets or drops below the breakeven point. As such, this type of investment isn’t meant for the average investor. You should have a better understanding of the markets and experience if you wish to take on this kind of risk.
What Happens When an Option Is Exercised?
Call options allow the buyer the right (but not the obligation) to buy the underlying asset, whether that’s stock, bonds, commodities, currencies, or any other financial security. The buyer has the right to do so at the specified price by the expiration date. The call option is exercised when the buyer decides to buy the underlying asset. If they choose to do so, the seller must deliver the asset in question to the buyer.
Why Is a Regular Call Called a Naked Call?
A regular call is commonly referred to as a naked call because the contract holder doesn’t own the underlying asset. It is also called a short call because the seller takes a short position in the account on the underlying asset. There is inherent risk involved with this strategy—notably, if there is a great increase in the asset’s price and if the buyer decides to exercise the option. If the latter occurs, the seller must purchase the asset and deliver it to the buyer.
The Bottom Line
Trading options like covered calls and regular calls can be tricky and complicated. Investors must consider the varying factors involved, such as ownership in the underlying asset, market views, and positions in the asset, as well as the risks involved. Although there may be big rewards to reap, they call options aren’t meant for the average investor. You should have some experience and do your research before you dive into the world of options.