What is a Covered Call?
A covered call strategy involves holding a long position in an underlying asset, such as stocks, while simultaneously selling a call option on the same asset. The key to this strategy is that the "call" option is covered because you already own the underlying asset that could be called away (or sold) if the option buyer exercises the option.
Here's how it works:
Buy the Underlying Asset: First, you purchase shares of a stock that you believe has moderate upside potential but may not move significantly in the short term.
Sell a Call Option: Next, you sell a call option on the stock you own. The option strategy gives the buyer the right to purchase the stock at a specified price (strike price) by a specific expiration date.
In return for selling the call option, you receive a premium (income). This premium provides some downside protection and also enhances your overall return on the stock if the stock doesn't rise dramatically above the strike price.
How Does a Covered Call Work?
Let’s break down an example to see how a covered call works in practice:
Step 1: You buy 100 shares of XYZ stock at $50 per share.
Step 2: You sell one call option on XYZ stock with a strike price of $55, expiring in 30 days, and receive a premium of $2 per share.
Step 3: There are two possible outcomes:
Stock Price Rises Above Strike Price: If the stock price rises above $55 by the expiration date, the option buyer may exercise the option and buy your shares at $55. You would make a profit of $5 per share from the sale of the stock, plus the $2 per share premium, giving you a total profit of $7 per share.
Stock Price Stays Below Strike Price: If the stock price stays below $55, the option expires worthless, and you keep the $2 per share premium as profit. You also still own the 100 shares of stock, and you can sell another call option, repeating the process.
Benefits of a Covered Call
Generate Extra Income: By selling the call option, you receive a premium, which provides additional income on top of any dividends or capital gains from the underlying stock.
Downside Protection: The premium from selling the call offers some protection against a small decline in the stock price. While this won't completely offset large losses, it can cushion smaller price drops.
Limited Risk: Since you already own the stock, the risk of a covered call strategy is relatively low. Your downside risk is the same as holding the stock outright, but the premium from selling the call can reduce the cost basis of the stock.
Risks of a Covered Call
While the covered call strategy is relatively low-risk compared to other options strategies, there are some downsides:
Limited Upside Potential: The most significant drawback is that you limit your upside potential. If the stock price rises significantly above the strike price, your gains are capped at the strike price plus the premium you received.
Stock Ownership Risk: You are still exposed to the full downside risk of owning the underlying stock. If the stock price drops substantially, the premium you received won’t fully offset your losses.
When to Use a Covered Call
Covered calls work best in neutral to mildly bullish markets. If you believe that a stock will stay relatively flat or rise slightly over time, selling covered calls can generate consistent income. However, if you anticipate large price movements, a covered call might not be the right strategy because it limits your potential upside.