Covered Call
tl;dr
A covered call is a strategy where you own an asset (like stocks) and sell a call option on that asset to generate additional income from the option premium. It works best when you expect little price movement or slight increases in the stock price. If the stock price stays below the strike price, you keep the premium and the stock. If the stock price rises above the strike price, you must sell the stock at the strike price, but you still keep the premium. This strategy is ideal for neutral-to-bullish market outlooks and offers income generation with limited risk.
Definition.
A strategy where a trader holds a long position in a stock and sells call options on the same stock. Opposite of uncovered call.
Real-World Example.
A covered call is an options trading strategy where an investor holds a long position in an asset (like stocks) and sells a call option on that same asset. It’s often used to generate additional income from the premium received for selling the option, especially in a market where the investor expects little price movement or slight upward movement in the stock.
For example, imagine you own 100 shares of XYZ stock, which is currently trading at $50 per share. You believe the stock will not rise much above $55 in the next month. To generate extra income, you sell a call option with a strike price of $55, receiving a premium of $2 per share. If the stock price remains below $55, you keep both the shares and the premium. However, if the stock price goes above $55, you must sell the shares at $55, but you still keep the $2 premium you received from selling the call option.
How the Covered Call Works.
- Own the Asset: To use the covered call strategy, you first need to own the underlying asset (such as 100 shares of stock). The number of options contracts you can sell depends on how many shares you own, since each option contract typically represents 100 shares.
- Sell a Call Option: You sell a call option for the asset you own. This gives the buyer the right (but not the obligation) to purchase your shares at the strike price of the option before the option expires.
- Receive the Premium: By selling the call option, you collect the premium from the buyer. This is the income you earn from using the covered call strategy.
- Expiration and Potential Outcomes:
- If the stock price stays below the strike price: The option will likely expire worthless, and you keep both your stock and the premium.
- If the stock price rises above the strike price: You will be forced to sell your stock at the strike price (which is higher than the current market price), but you keep the premium received from selling the option. This limits your upside profit, but you still make money from the premium.
How to Use the Covered Call Strategy.
- Determine Your Market Outlook: The covered call strategy works best when you expect little movement or slight price appreciation in the underlying asset. It’s a strategy designed for a neutral-to-bullish outlook.
- Choose the Right Strike Price: The strike price is crucial to the strategy. Choose a strike price that is above the current market price if you want to limit your potential profits. A strike price farther out-of-the-money will provide a higher chance of keeping the stock, but a lower premium. Conversely, a strike price closer to the market price offers higher premiums but increases the chance of the stock being called away.
- Set the Expiration Date: The expiration date is the date by which the option must be exercised. If you sell a short-term call, you get quick income but have the risk of having your stock called away sooner. If you sell a long-term call, you earn a lower premium, but you keep the potential for the stock to appreciate.
- Monitor and Adjust: If the stock price rises sharply, you may want to adjust your strategy or roll over your position by buying back the option and selling a new one with a higher strike price. This way, you can still profit from the upside while keeping the premium.
- Risk and Reward: The risk with the covered call strategy is that you may miss out on large gains if the stock price increases significantly. Your profit is limited to the strike price plus the premium you received, so if the stock moves much higher than that, you won’t capture those gains.
