The covered call is an options trading strategy that allows investors to potentially earn income from their existing stock holdings while providing some downside protection. This strategy is relatively straightforward and is commonly used by investors seeking to generate additional returns from their stock investments. Let’s break down the covered call strategy in simple terms:
1. The Basics of Covered Call:
In a covered call strategy, an investor (the seller) who already owns a certain number of shares of a particular stock writes (sells) call options on those shares. Each call option represents the right, but not the obligation, for someone else (the buyer) to purchase the shares from the investor at a predetermined price, known as the “strike price,” within a specific period, called the “expiration date.”
2. How Covered Call Generates Income:
When an investor sells call options against their stock holdings, they receive a premium (the price of the options) from the buyers. This premium is income for the investor, and they get to keep it, regardless of what happens with the options later on.
3. The Risk-Reducing Aspect:
The strategy is called “covered” because the investor already owns the underlying stock that the call options are based on. If the call option buyer exercises the option and buys the stock from the investor, the investor can deliver the shares they already own, covering the obligation. This means the investor doesn’t need to buy the stock in the open market to fulfill the contract.
4. The Potential Outcomes:
- If the stock price remains below the call option’s strike price until the expiration date, the call options will likely expire worthless, and the investor keeps the premium as income. They can repeat the strategy by selling more covered calls if they wish.
- If the stock price rises above the call option’s strike price, the call option buyer may exercise the option and buy the stock from the investor at the strike price. In this case, the investor earns the premium from selling the call options, plus any profit made from selling the stock at a higher price than they bought it for.
5. Example of Covered Call:
Let’s say you own 100 shares of XYZ Company, currently trading at $50 per share. You think the stock’s price won’t increase much in the near term, so you decide to use a covered call strategy. You sell one call option contract with a strike price of $55 and an expiration date one month away. For selling this call option, you receive a premium of $2 per share (total premium = $200).
Possible Outcomes:
a. If the stock price stays below $55 until the expiration date, the call option expires worthless, and you keep the $200 premium as income.
b. If the stock price rises to $60, the call option buyer may exercise the option, and you sell your shares to them at $55 per share. In addition to the $200 premium, you make a $500 profit ($60 – $50 = $10 profit per share).
6. Considerations:
- Covered call strategy limits potential gains if the stock price surges significantly.
- It provides a way to generate income and potentially lower the effective cost basis of the stock.
- Investors should carefully choose the strike price and expiration date based on their outlook for the stock and market conditions.
In summary, the covered call strategy can be an effective way for investors to generate income from their stock holdings while potentially benefiting from limited stock price appreciation. However, like all investment strategies, it comes with risks, and investors should thoroughly understand the mechanics and risks before implementing it in their portfolio. Consulting with a financial advisor is always a good idea to ensure the strategy aligns with individual financial goals and risk tolerance.