A covered call is when an investor sells call options and holds the same amount of underlying securities.
Key Takeaways
- A covered call is a financial transaction in which an investor who holds a long position in an asset writes (sells) call options on that same asset to generate an income stream.
- Covered call options can be beneficial when you don’t expect a stock to do much and want an additional income from your stock investments.
- Regarding investing in stocks, there are two main strategies: stock ownership and covered calls.
What Is a Covered Call?
A covered call is a financial transaction in which an investor who holds a long position in an asset writes (sells) call options on that same asset to generate an income stream. This strategy is known as the “covered” call because the investor owns an equivalent amount of the underlying security, meaning they can deliver the shares if the buyer of the call option chooses to exercise. By writing a covered call, investors can benefit from both capital appreciation and income generation simultaneously.
The potential downside of this strategy is that it limits upside potential since any gains above the strike price will be offset by losses from selling calls. Additionally, if the stock price falls below the strike price, then there will be no gain from selling calls, and investors may incur losses due to their long position in the asset. Therefore, it is important for investors to carefully consider their risk tolerance before engaging in this type of strategy.
Why Use a Covered Call?
Covered call options can be beneficial when you don’t expect a stock to do much and want an additional income from your stock investments. If the stock follows the initial pattern, then the premium is kept. But if it surpasses your option’s strike price before expiration, you’ll have to sell your shares at that price but still keep any profits up to then.
Why Avoid a Covered Call?
If you expect the shares of stock to rise in the near future, it makes little sense to sell away its potential upside in exchange for a relatively small amount of money. In this case, holding on and letting the stock rise is better before considering setting up a covered call. Additionally, if you think the stock has serious downside risk, don’t use a covered call as an attempt to get extra cash from what looks like an impending drop. This could cost you more than it’s worth if the stock does indeed fall significantly.
How Does a Covered Call Work?
A covered call is a prevalent choice trading procedure that includes selling a call alternative for every 100 shares of the base stock they possess. This approach permits traders to gain income from their stock holdings while holding potential losses in check. When creating a covered call, the dealer offers away some of the stock’s potential yield for an option premium. If the stock cost climbs, the trader won’t have an advantage as much as if they hadn’t sold the call alternative. However, by possessing the underlying stock, they restrain any possible misfortunes should the stock skyrocket.
At expiration, one of two things will happen: either the option will be exercised, and you will be obligated to sell your shares at the strike price, or it will expire worthless, and you can keep your shares and pocket any profits from selling the option. If you choose to keep your shares after expiration, you can write another covered call against them and repeat this process until you close out your position. Covered calls are an effective way to generate stock income while limiting risk.
Pros and Cons of Covered Calls
Pros:
A covered call is a popular strategy among investors looking to generate income from their stock positions. It involves buying a stock and then selling a call option on the same stock. This strategy offers several advantages, including generating income from a position that may or may not pay a dividend, relatively low risk, and an easy setup.
The covered call can reduce the risk associated with a position by allowing you to receive additional compensation should the stock price go down. It also provides an ongoing stream of income when done simply by repeating the process – that is, if you maintain ownership of your stocks and the call eventually expires worthless.
Cons:
The covered call is a popular strategy for generating income from stocks, but it also has some drawbacks. One of the main disadvantages of a covered call is that it offers limited upside in exchange for downside protection. This means that while you can earn a relatively small amount of income, you must bear any downside from the stock, leading to a potentially lopsided risk-return setup. Additionally, by setting up a covered call, you are trading away all the stock’s upside potential until the option’s expiration. If the stock rises, you lose out on gains that could have been earned.
An additional drawback of executing a covered call is that it may restrict your asset until the end of the option period. In addition, by uploading a call option, you might be reluctant to trade in your stock until the option runs out, although you could obtain back the call choice and then shift the stock. Finally, this system necessitates more capital to initiate than other options strategies, encompassing procuring stock and selling an option permits. Consequently, if capital is difficult for you, then this procedure may not satisfy your requirements.
Stock Ownership vs. Covered Calls
Regarding investing in stocks, there are two main strategies: stock ownership and covered calls. Stock ownership is the simplest option, as you buy shares of a company and accept the risk that their value may decrease. On the other hand, selling a covered call can be more profitable in some cases. This strategy involves writing an option contract to sell your shares at a predetermined price (the strike price) within a certain period. If the share price rises above the strike price before expiration, you will profit up to that amount plus the premium received for writing the option contract.
However, if the share price does not reach or exceed the strike price before expiration, then you will only profit from any increase up to that point plus the premium received for writing the option contract. This means that if you had just held onto your stock instead of selling a covered call, you would have profited from any further increases in share price beyond what was listed in your option contract. Therefore, when deciding between stock ownership and selling a covered call, it is important to consider both potential profits and risks associated with each strategy.
Conclusion
The bottom line with the covered call strategy is that it can be a great way for investors to generate income while limiting their downside risk. By selling calls on stocks they already own, investors can collect premiums and benefit from any increase in stock prices up to the option’s strike price. This strategy can be especially beneficial for those looking for a steady income and who don’t want to take on too much risk.
Covered Calls FAQ
Are covered calls a profitable strategy?
Depending on the trading strategy covered, calls can be profitable or not. The greatest payment from a covered call is achieved when the stock cost ascends to the level of the option that was sold, yet no greater.
Are covered calls risky?
Covered calls are seen as a reasonably low danger. Nevertheless, such calls would limit any extra potential gains if the stock stayed on an upswing and would not furnish a lot of protection against a descending stock price. Make sure that, not like covered calls, the persons who offer options without having equal amounts of the underlying shares are considered naked call purveyors. Naked short calls theoretically have boundless loss capacity if the fundamental security soars.
