In a covered call, a seller sells buyer call options at a predetermined strike price and time to expiration on securities that the seller already owns. Professional traders use covered calls as a tool to boost the return on their portfolios. Individual investors who take the time to learn how they operate and when it is appropriate to use them can also use covered call options as a cautious but effective strategy.
See how a covered call can increase your income, lower the risk in your portfolio, and improve the performance of your investments in the following paragraphs.
How Do Covered Calls Work?
One of your many advantages as a stock/futures contract holder is the ability to sell your holdings at any time for market value. By selling this right through covered call writing, you can give someone else the opportunity to buy your security at a predetermined price known as the striking price on or before the expiration date in exchange for money.
The buyer of a call option has the right, but not the obligation, to acquire the underlying stocks or futures contract at the option’s strike price before the option’s expiration. If the call option seller also owns the underlying securities, the option can be exercised without requiring the seller to purchase the asset at market value. This situation is known as being “covered.”
Covered Calls: How To Make Money
For the privilege of purchasing shares or contracts at a certain price in the future, the buyer of a call option will pay a premium to the seller of the option. The premium paid on the day the option is sold is the seller’s regardless of whether the option is ultimately exercised or not.
Because of this, the covered call strategy is the most profitable if the stock increases above the strike price and a profit from the long stock position is realized. The writer of the call will keep the entire premium they received from selling the option if the buyer of a covered call does not exercise before the option expires because they do not believe the price of the underlying stock will rise.
The call’s seller will sell the underlying shares at the strike price and keep the premium if the option’s buyer exercises it. However, by selling at the strike price, the seller forgoes any potential value gains brought on by a rise in the share price.
When Is It Appropriate To Sell A Covered Call?
Future appreciation is the price to be paid for getting paid when selling a covered call. Let’s say you put $50 into XYZ stock with the hope that it will rise to $60 in a year by 20%. In addition, you’re ready to sell at $55 within the next six months, giving up future gain for a quick profit. In this circumstance, selling a covered call on the trade can be beneficial. Selling a covered call on the position in this situation might be advantageous.
The current premium on the sale of a $55 call option with a six-month expiration date is $4 per share, according to the option chain for the stock. You could sell that option if, after purchasing shares at $50 each, you thought they might be worth $60 in a year. The investor will be required to sell their shares if the underlying price increases to $55 within six months of the covered call’s writing. If you sell 100 shares for $55, you will receive $59 in return. You also get to keep the $4 premium, which amounts to an 18% return over the course of six months.
The buyer won’t exercise the option because they can purchase the shares for less than the contract price, so you will lose $10 on the initial position if the stock falls to $40. The $4 premium from the call option transaction, however, is yours to keep, so the loss per share drops from $10 to $6.
Advantages Of Using Covered Calls
Selling covered call options in exchange for potential gains over the strike price plus a premium for the length of the contract can assist lower downside risk or maximizing upside gain. The seller thus earns less money than they would have if they had simply held onto the XYZ stock and allowed it to increase to a closing price of $59 instead. If throughout the six-month term the stock price decreases and finishes at less than $59 per share, the seller will either realize a profit or sustain a smaller loss than they otherwise would have.
Disadvantages Related To Covered Calls
Sellers who do not own the underlying shares/contracts are known as “naked call holders,” leaving them exposed to potentially illimitable risk in the event that the value of the underlying security increases. Sellers must buy back their option holdings before selling shares or contracts, which raises transaction costs while lowering or increasing net gains or losses, as appropriate.
Final Note
For option holders looking to generate income, covered calls can be a low-risk option. Retirees who don’t want to sell their positions but could use some extra cash flow find covered calls to be particularly appealing. With a covered call, you can earn a modest profit while taking on a little risk.
