Covered Call: Selling a call option while already owning the underlying stock
Introduction
Welcome to our article on "Covered Call" options! In this guide, we'll explore what covered calls are, how they work, their benefits and risks, examples of covered call strategies, and frequently asked questions about covered calls.
What is a Covered Call?
A covered call is an options trading strategy where an investor sells a call option on a stock they already own. This strategy allows the investor to earn additional income through the premium received from selling the call option, while still holding the underlying stock.
How Covered Calls Work
Here’s how covered calls function:
- Owning the Stock: The investor must own the underlying stock in the quantity required by the call option contract (typically 100 shares per contract).
- Selling the Call Option: The investor sells a call option on the owned stock, agreeing to sell the stock at a specified strike price if the option is exercised.
- Receiving the Premium: The investor receives a premium for selling the call option, providing additional income.
Benefits of Covered Calls
Key benefits of covered calls include:
- Income Generation: The premium received from selling the call option provides additional income on top of any dividends from the underlying stock.
- Downside Protection: The premium received can offset some of the potential losses if the stock price decreases.
- Improved Returns: Covered calls can enhance overall returns in a flat or moderately bullish market.
Risks of Covered Calls
Key risks associated with covered calls include:
- Limited Upside Potential: If the stock price rises significantly above the strike price, the investor may miss out on potential gains, as they are obligated to sell the stock at the strike price.
- Stock Ownership Risk: The investor still bears the risk of owning the stock, which can decrease in value.
- Option Assignment: If the stock price exceeds the strike price, the call option may be exercised, and the investor will have to sell the stock at the strike price.
Example of a Covered Call Strategy
Example scenario illustrating a covered call strategy:
- Owning the Stock: An investor owns 100 shares of XYZ Corporation, currently trading at $50 per share.
- Selling the Call Option: The investor sells a call option with a strike price of $55, expiring in one month, for a premium of $2 per share.
- Potential Outcomes:
- If XYZ's stock price remains below $55 at expiration, the option expires worthless, and the investor keeps the premium.
- If XYZ's stock price exceeds $55 at expiration, the option is exercised, and the investor sells the shares at $55, keeping the premium.
- If XYZ's stock price decreases, the premium received offsets some of the losses.
FAQs about Covered Calls
Q1: Can I use covered calls on any stock?
A: Covered calls can be used on any stock that has options available. However, it's generally recommended to use this strategy on stocks that the investor is willing to hold long-term.
Q2: How do I choose the strike price for a covered call?
A: The strike price should be chosen based on the investor's outlook for the stock and their desired level of income versus potential for capital gains. A higher strike price offers more potential for capital gains but less premium income, and vice versa.
Q3: What happens if the stock price exceeds the strike price?
A: If the stock price exceeds the strike price at expiration, the call option will likely be exercised, and the investor will have to sell the stock at the strike price, potentially missing out on further gains above that price.
Conclusion
Covered calls are a popular options strategy that can generate additional income for investors who already own the underlying stock. By understanding how covered calls work, their benefits and risks, and how to implement them effectively, investors can enhance their trading strategies and achieve better returns. Stay tuned for more articles as we continue to explore various financial and investment topics!