Definition
A covered call is an investment strategy where an investor sells call options on a stock they already own. This provides immediate income (the premium from selling the options) but obligates the investor to sell the stock at the call’s strike price if the call option is exercised. It’s a strategy used primarily when an investor has a neutral or slightly bullish view on the stock.
Phonetic
The phonetics of the keyword “Covered Call” is: /ˈkʌvərd kɔːl/
Key Takeaways
- Income Generation: Covered calls are primarily used to generate income on an existing long position in stocks or securities. The seller collects a premium that can partially or entirely offset potential losses in the stock.
- Limit Profit Potential: While covered calls can generate an income stream, they limit the extent of possible profits in return. If the stock price soars, the call option gets exercised, forcing the seller to sell the stock at a price lower than the market value.
- Risk-Lowering Strategy: Another major takeaway is that covered calls are a risk-lowering strategy. They can help mitigate minor drops in the underlying stock price, but they offer minimal protection against significant stock price drops as the potential loss can far exceed income received from the premium.
Importance
Covered Call is a critical strategy in options trading that allows an investor to earn an income via premiums derived from selling call options against shares they already own. This strategy is important because it provides a way to generate additional income on top of any dividends earned from the owned shares. Essentially, it acts as a hedging tool allowing investors to mitigate potential losses during bearish market conditions. However, it also limits the potential profit if the underlying stock prices rise beyond the strike price. Therefore, a proper understanding and application of the covered call strategy can serve as an effective risk management tool, enhancing the efficiency of an investment portfolio.
Explanation
A covered call is essentially a financial market transaction, used by investors and traders who are looking to potentially profit from their assets in the short term without actually having to sell their holdings. This is a popular income-producing strategy where an investor sells, or “writes” , call options against shares they already own. In short, it’s a way for investors to earn some revenue off their portfolio, especially if they believe that the shares they hold will not experience a significant increase in the near or mid-term. The primary purpose of employing a covered call strategy is to generate additional income from an owned stock, beyond any dividends or capital appreciation. It is fundamentally a conservative strategy, meant to enhance portfolio returns during flat or slightly upward trending markets. It allows an investor to collect premiums from the sale of the call options, giving the buyer the right to buy the investor’s stock at a predetermined price. This strategy can be an effective way to enhance the return on equity in a portfolio especially in a stagnant market, however, there is a trade-off as it potentially limits the upside gain if the stock price rises significantly.
Examples
1. Stock Investment: Sarah owns 100 shares of XYZ Company that she bought for $50 a share. The current price is $55 per share. She writes a covered call option for one month in the future with a strike price of $60 for $2.50. If the price goes above $60, she is obligated to sell her shares, making a $10 profit per share and keeping the premium. If the price stays below $60, her stocks aren’t sold, and she keeps the premium.2. Portfolio Insurance: John has a portfolio of blue-chip stocks that have been performing well. To hedge against a potential downturn, he writes covered calls on his holdings. The premium received from the call option provides a cushion against potential losses, reducing the overall risk of his portfolio.3. Income Generation: Rebecca owns substantial shares of a stable but slow-growing company and wants to generate additional income from her holdings. She decides to write a covered call, selling the right to purchase her stocks at a higher price. This way, she receives the premiums from the call option as immediate income, while still potentially benefiting from any moderate growth in the stock’s price.
Frequently Asked Questions(FAQ)
What is a Covered Call?
A Covered Call is an investment strategy where an investor writes (or sells) call options on the securities that they already own in their portfolio. This approach is typically used to generate additional income from the invested security.
Why would one use a Covered Call strategy?
Investors might utilize a Covered Call strategy to generate additional income streams, especially in a flat to slightly upward market (bullish). It allows the investor to earn from the premiums received from selling call options.
What are the potential risks involved with a Covered Call?
The risk of a Covered Call strategy arises when the market price of the underlying security rises significantly. In such a scenario, the investor would miss out on capital gains as the written call option would likely be exercised.
What is the difference between a Covered Call and an Uncovered Call?
In a Covered Call strategy, the investor owns the underlying security over which they are writing call options. In contrast, an Uncovered (Naked) Call strategy would involve writing call options over securities not owned by the investor. The latter is associated with significantly more risk.
Can I use Covered Call strategy with any type of security?
The Covered Call strategy is usually associated with stocks. However, it can technically be used with any type of security for which there is an options market.
How much income can I generate from a Covered Call?
The income generated from a Covered Call mainly depends on the premium price of the call options sold. Premium prices can vary with several factors, including how much time is left until the option’s expiration date and the volatility of the underlying security.
What happens when the call option I sold is exercised?
If the call option you sold (wrote) is exercised, you will be obligated to sell your underlying security at the strike price. That’s why a Covered Call strategy is employed when an investor has a neutral or a slightly bullish view on the market.
Is a Covered Call strategy suitable for beginners in trading?
While the concept of a Covered Call strategy is basic to understand, it does require an understanding of options trading. Therefore, it is generally recommended for individuals who already have some knowledge and experience of the options market.
Related Finance Terms
- Option premium
- Call option
- Underlying asset
- Strike price
- Expiration date
