Covered Call vs. Regular Call: What's the Difference?

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.

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.

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

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.

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.