A covered call is an options trading strategy that involves holding a long position in an underlying asset (e.g., stocks) and simultaneously selling (writing) call options on the same asset. It’s a popular strategy among investors who want to generate additional income from their stock holdings while potentially limiting their downside risk.
How the covered call strategy works –
- Buy the Underlying Stock: You start by owning shares of a stock or ETF in your portfolio. The number of shares you own determines how many covered calls you can write.
- Sell Call Options: Simultaneously, you sell (write) call options on the same stock you own. Each call option represents the right (but not the obligation) for the buyer to purchase a certain number of shares of the underlying stock at a specified strike price before a specific expiration date.
- Choose Strike Price and Expiration: When selling the call options, you need to select a strike price and an expiration date. The strike price is the price at which the buyer can purchase your shares if they decide to exercise the option. The expiration date is when the option contract expires.
- Receive Premium: In exchange for selling the call options, you receive a premium from the option buyer. This premium is your immediate income and represents compensation for granting the option buyer the right to buy your shares at the strike price.
- Obligation to Sell: When you sell a covered call, you have an obligation to sell your shares at the strike price if the option buyer decides to exercise the option before or on the expiration date. This can happen if the stock’s price rises above the strike price.
The covered call strategy can have several outcomes:
- Option Expires Worthless: If the stock price remains below the strike price at expiration, the call option will expire worthless, and you keep the premium you received as a profit. You can continue selling covered calls on the same stock for additional income.
- Stock Is Called Away: If the stock price rises above the strike price, the call option buyer may exercise the option, and you will be obligated to sell your shares at the strike price. While you still keep the premium received, your potential profit from the stock’s price appreciation is capped at the strike price.
- Rolling the Option: If the stock’s price approaches or surpasses the strike price, you may choose to buy back the call option and sell another call option with a later expiration date and a higher strike price. This allows you to keep the stock and generate additional premium income.
Advantages of the covered call strategy include –
- Generating income from stock holdings.
- Potentially reducing the effective cost basis of the stock.
- Providing some downside protection through the premium received.
However, there are also disadvantages and risks, including –
- Limited upside potential if the stock’s price rises significantly.
- The potential for losing the stock if it’s called away.
- The risk of the stock declining in value.
The covered call strategy is generally considered conservative and is often used by investors with a moderately bullish or neutral outlook on the underlying stock. It’s essential to carefully consider your investment goals, risk tolerance, and the specific characteristics of the stock before implementing this strategy. Additionally, it’s recommended to have a thorough understanding of options and risk management techniques.
