Volatility Paradox

Overview

The Covered Call is often the first strategy an option trader learns. It is an income-generating trade that combines owning 100 shares of a stock with selling (writing) a call option against those shares.

By selling the call, you collect a "rent" (premium) from the buyer. In exchange, you give up any potential profit if the stock price rallies above the strike price you chose.

[!TIP] This strategy is like owning a rental property. The stock is the property, and the call premium is the rent. The "catch" is that you've agreed to sell the property if the price hits a certain level.

The Setup

A Covered Call consists of:

Long Stock: Own at least 100 shares of the underlying.
Short Call: Sell 1 call option for every 100 shares you own.

Mechanics of Income

When you sell the call, the cash (premium) is deposited into your account immediately.

Scenario A (Stock stays below strike): The call expires worthless. You keep the shares and the premium. You can now sell another call for next month.
Scenario B (Stock rises above strike): You are "assigned." You must sell your 100 shares at the strike price. You keep the premium plus the profit on the stock up to the strike.

Payoff and Break-even

Max Profit

Your profit is capped. It's the distance between your purchase price and the strike, plus the premium you collected:

\text{Max Profit} = (K - S_0) + C_0

Break-even Point

The premium you received effectively lowers the price you paid for the stock:

\text{Break-even} = S_0 - C_0

The "Concave" Greeks

Selling a call makes your overall position "Concave." This means your risk/reward profile is the opposite of a simple call buyer's.

1. Delta: Reduced Speed

A stock position has a Delta of 1.0. A Covered Call has a Delta of less than 1.0 (usually 0.60 to 0.80).

If the stock goes up $1, your position only goes up$ 0.70.
This is because your gains on the stock are partially offset by your losses on the short call.

2. Theta: Your Best Friend

In this strategy, you are a Volatility Seller. Time decay (Theta) works in your favor. Every day the stock stays below the strike, the call you sold loses value—meaning you're winning.

3. Gamma: The Downside Risk

Covered calls have Negative Gamma. This means the "speed" of your position increases to the downside. If the stock crashes, your Delta moves back toward 1.0, and you lose money just as fast as any other stock owner.

When to Sell?

Low Growth Expectations: You think the stock will stay flat or move up only slightly.
High Implied Volatility: If IV is high, call premiums are "fat"—you get more rent for your shares.
Target Exit: You were planning to sell the shares around a certain price anyway. Why not get paid to wait for it?

The Dividend Trap

If you sell a covered call on a stock that pays a dividend, watch the Ex-Dividend Date closely.

If the dividend amount is greater than the remaining time value (extrinsic value) of your short call, the call buyer has a massive incentive to exercise early to capture the dividend. You'll wake up to find your shares "called away" just before the dividend hits your account.

Checklist for Entry

Am I willing to part with my shares at the Strike Price?
Is the premium worth the "capped upside" risk?
Have I checked the Ex-Dividend Date? (Dividends can trigger early assignment).

The Yield Enhancement MathRead more

To calculate your "Static Return" (if the stock doesn't move):

\text{Yield} = \frac{\text{Premium}}{S_0 - \text{Premium}} \times \frac{365}{\text{Days to Expiration}}

This is the annualized "rent" you are earning on your net capital investment. Professional income funds use this metric to compare covered calls across different stocks.

Covered Call