Covered Calls: What You Need To Know
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Published on: 03 March 2023
Last Updated on: 09 October 2024
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A covered call transaction involves a seller selling call options on securities that the seller already owns to buyers at a predetermined strike price and period to expiration.
Covered calls are used by seasoned traders to boost their returns. Individual investors who take the effort to learn how covered call options work and when they are acceptable to use can benefit from this cautious but effective approach.
Read on to find out how a covered call can improve your investment returns while also increasing your income and decreasing your portfolio’s risk.
A Covered Call Is…
One of the perks of owning stocks or futures contracts is the option to sell them at any time for their current market value.
When you engage in covered call writing, you sell this right to another party in exchange for payment. The option buyer then acquires the right to buy your securities on or before the expiration date at a set price, known as the striking price.
The purchaser of a call option is granted the right, but not the responsibility, to acquire shares of stock or futures contracts at the option’s strike price at any time before the option expires.
The seller of a call option is considered to be “covered” if they also possess the stocks underlying the option, meaning that the buyer of the option is not obligated to buy the instrument at market price.
How Covered Calls Can Boost Your Income
A premium is paid to the seller of a call option in exchange for the buyer’s right to acquire shares or contracts at a certain future price (the strike price). The option premium received on the day of sale remains to the seller regardless of whether or not the option is exercised.
Consequently, the covered call strategy is the most lucrative if and only if the stock climbs over the strike price, resulting in a profit from the long stock position.
The premium earned for selling the option belongs to the writer of the call if the covered call buyer does not expect the underlying stock price to rise and does not exercise before the option expires.
The seller of a covered call receives the premium paid by the option’s buyer if the buyer exercises their option to purchase the underlying shares at the strike price. But if the seller sells at the strike price, he or she will not receive any appreciation in value from an increase in the share price.
When Is It Appropriate To Sell A Covered Call?
Covered calls are a way to generate income in exchange for the risk of missing out on potential appreciation. Consider a hypothetical investment of $50 in XYZ stock with a 20% annualized return: $60 after one year.
You are willing to forego future gain in exchange for a quick buck, selling your shares for $55 within the next six months. Selling a covered call on the trade could be useful in this instance.
A call option with a strike price of $55 and a term of six months is now trading at a premium of $4 per share, as shown by the option chain for this stock. Suppose you invested $50 a share but anticipate that they will be worth $60 in a year. You could profit by selling your call option.
The investor is required to sell their shares if the underlying price increases to $55 within the six-month period after the covered call is written. To illustrate, if you sell 100 shares at $55, you’ll receive $58. Six months later, you’ll have earned 18%, and the premium of $4 is all yours to keep.
If, on the other hand, the stock price drops to $40, you will lose $10 on the original position since the buyer will not exercise the option because they can purchase the shares for less than the contract price. But, since you get to keep the $4 premium from the call option transaction, your loss per share is only $6 instead of $10.
Covered Calls Are Advantageous In Many Ways
Covered call options can be used to hedge against loss or maximize possible gain by accepting a premium in exchange for the possibility of the underlying asset appreciating more than the strike price plus premium during the contract period.
Simply put, the seller loses money since they might have made more money by holding on to the XYZ stock and seeing it climb in price to a closing price of $59 rather than selling it.
The seller will either make a profit or incur a lower loss than if the options transaction had not occurred if the stock price drops throughout the course of the six-month period and finishes at less than $59 per share.
Consequences Of Covering Calls
Those who sell calls but don’t own the underlying stock or contract are called “naked call holders” and are at risk of infinite losses if the price of the underlying security rises.
It increases transaction costs and reduces or increases net gains or losses, respectively, when sellers have to buy back options holdings before expiration in order to sell shares or contracts.
Final Note
Covered calls are a popular way for retirees who don’t want to sell their positions but might use some extra cash flow to generate income with minimal risk. A covered call is a way to earn a return with little to no risk.
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