Definition
A covered call is an investment strategy where an investor sells call options against shares of a stock they already own. This way, the investor earns a premium income from the sold call options. However, they also limit their upside potential if the stock goes above the option’s strike price, as they are obliged to sell the stock at that strike price.
Key Takeaways
- A Covered Call is an investment strategy in which an investor sells call options on a stock they already own or have bought specifically for this purpose. This strategy enables the investor to earn an income from the premium received for selling the call options.
- The primary goal of writing a Covered Call is to enhance income or return on investment for the underlying stock, which would not only have to rise for the investor achieves a profit, but it should rise at least up to the strike price before the options’ expiry date.
- However, the Covered Call strategy also limits the upward potential of the underlying stock. If the stock price rises significantly, the investor may miss out on the full benefit because they are obliged to sell the stock at the strike price of the call option they have sold.
Importance
A covered call is an important strategy in options trading that allows an investor to earn an income by selling call options on securities they already own. This strategy is helpful in generating profits during stable or slightly bearish market conditions.
Essentially, the investor is agreeing upon selling their securities at a set price before the options expire, hoping the market price will not exceed this. If the market price stays below the agreed price, the investor keeps the premiums and their existing securities.
Therefore, implementing a covered call serves as a moderate risk-mitigating technique that can provide an additional income stream for the investor while maintaining their market position. However, in the scenario that the market price climbs significantly higher than the agreed price, the investor loses the opportunity for capital gains.
Explanation
Covered calls serve a dual purpose in the financial world: increased investment income and downside protection. Investors and traders use this strategy to generate additional income beyond that of their investments’ regular dividends. The process involves owning the underlying security and then selling call options on a share-for-share basis.
Consequently, if the options are exercised, the holder is obligated to sell the underlying security at the strike price, equating to a potential profit. More so, this premium obtained from selling or “writing” these call options can generate regular revenue that can significantly enhance overall investment returns. Covered calls are also used as a strategy to provide some level of protection against downside risk.
While this strategy doesn’t completely mitigate the loss if a stock’s price falls significantly, it offers a cushion to offset minor price declines in the underlying security. In essence, the income from the sale of call options works to compensate for any depreciation in the security’s value to a degree. Therefore, a covered call strategy can offer income and a limited protection layer, helping to manage risk in a cost-effective way.
Examples of Covered Call
A covered call is a financial strategy in which an investor sells call options on a stock they currently own. This provides them with income from the option premium. Here are three real world examples:
ABC Stock Example: Let’s say an investor owns 1000 shares of ABC Company, which is currently trading at $50 per share. The investor wants to generate some income from this holding, so they sell 10 call option contracts (1 contract = 100 shares) with a strike price of $55 expiring in one month. The investor receives a premium of $2 per share or $2000 in total. If ABC stocks stay below $55, then the investor keeps the $2000 as profit. However, if the price goes beyond $55, the investor is obliged to sell at that agreed price.
Technology Stocks Example: A tech-savvy investor who owns significant shares in a technology company decides to write covered calls to generate additional income. The investor sells options with a strike price that is slightly higher than the current market value, anticipating that the price won’t increase drastically before the option’s expiration date. By doing so, the investor earns the premium and still maintains ownership of the shares if the price doesn’t reach the strike price level.
Mutual Fund Example: Some mutual funds employ a covered call strategy to generate additional income. These funds own a diversified portfolio of stocks and sell call options on their holdings. This approach allows the fund to earn income from option premiums, possibly providing fund investors with higher dividends. However, this strategy may also limit the fund’s upside potential because if a stock significantly appreciates in price, the fund is obligated to sell the stock at the lower strike price.
Covered Call FAQs
1. What is a Covered Call?
A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, like shares of a stock or other securities. It’s a type of strategy used to generate options income on an owned stock.
2. How does a Covered Call work?
In a covered call, you hold a long position in an asset and sell or write call options on that same asset in an attempt to generate more income. This is often used when an investor has a short-term neutral view on the asset and for this reason, holds the asset long and simultaneously has a short position via the option to generate income from the option premium.
3. Who uses Covered Calls?
Covered calls are typically used by investors and traders who might own shares but do not expect them to rise significantly in the near future. Thus, they’re willing to forfeit the right to benefit from an increase in exchange for the premium they receive for writing the calls.
4. What are the risks of using Covered Calls?
The risk of a covered call strategy is in the fact that it caps your potential profits. If the asset skyrockets in price, your gains are limited to the strike price of the call options you wrote. Furthermore, if the asset falls in price, you may lose money on your long position, although this may be somewhat offset by the premium you received.
5. Can you lose money on a Covered Call?
Yes, you can lose money in a couple of ways. If the asset’s price drops, you could lose the amount equal to the fall in the asset’s price less the premium earned from selling the option. If the asset’s price rises far above the option’s strike price, you lose the appreciation above the strike price. However, this loss is just an opportunity cost because you still profit up to the strike price.
Related Entrepreneurship Terms
- Option Premium
- Strike Price
- Expiration Date
- Underlying Asset
- In-The-Money (ITM)
Sources for More Information
- Investopedia: A comprehensive source that provides investing and finance education, including detailed explanations on the term “Covered Call”.
- Fidelity Investments: A multinational financial services corporation that offers explanations and resources about intermediate and advanced trading strategies like “Covered Calls”.
- Charles Schwab: A bank and brokerage firm that provides a wide range of resources for investors to understand different options strategies including “Covered Calls”.
- Options Playbook: The site provides practical guidance on a variety of options trading strategies, including “Covered Calls”.
