What Is A Covered Call?

When an investor trades call options against stock they already own or have purchased for such a transaction, it is known as a covered call. You grant the buyer of the call option the right to buy the underlying shares at a specific price and at a particular time by selling the call option.

Intro 

The covered call strategy is a trading strategy that entails selling call options. You purchase the stock you already have or recently purchased to produce additional income from those trades. The option you sell is called "covered "because you have enough stocks to protect the deal as required by the choice you've sold. Covered call methods can help investors receive income while limiting potential gains from stock price increases. Find out how a covered call strategy works and whether or not you should use it. A covered call is a common option technique for generating revenue through option premiums. 

When investors execute a covered call, they only expect a slight increase or drop in the underlying stock price over the option's term. When an investor owns a long position in an asset, (sells) call options on the same asset to execute a covered call. Covered calls are frequently used by investors who plan to retain the underlying company for a long time but do not anticipate a significant price gain shortly. This method is appropriate for investors who anticipate the underlying price will remain relatively stable in the short run.

What is a Covered Call?

A covered call is an investment in which the investor selling call options holds an equal quantity of the underlying security. An investor who owns a long position in an asset writes (sells) call options on that asset to make income. Because the seller has the ability to deliver the shares if the buyer of the call option exercises it, the investor's long position in the asset is the cover.  

Understanding Covered Calls. Covered calls are a neutral strategy. The investor only expects a modest increase or reduction in the underlying stock price during the written call option's life. 

This technique is commonly used when an investor has a short-term neutral perspective on an asset and, as a result, retains the asset long while also holding a short position via an option to profit from the option premium. Put, if an investor plans to keep the underlying stock for a long time but does not anticipate a significant price increase soon, they can make income (premiums) for their while waiting for the lull to pass.

A covered call is a short period of the hedge on a long stock manner that enables traders to earn from the option premium. However, if the price rises above the option's strike price, the investor loses his stock profits. If the buyer prefers to execute the option, they must furnish 100 shares at the strike price (for each contract written).

A covered call strategy isn't suitable for investors who are very bullish or negative. Extremely bullish investors are usually better off not writing the option instead of keeping the stock. If the stock price surges, the option caps the profit on the stock, which could reduce the overall gain of the investment. Similarly, suppose an investor is highly negative. It may be intelligent to sell the stock, as the premium obtained for writing a call option will be insufficient to balance its loss if it plummets.

How does a Covered Call Work?

A popular options strategy is the covered call. When compared to other options, it's frequently seen as low-risk. It might assist you in generating revenue from your investment portfolio. Many brokerages will let you sell covered calls even if you don't have permission to trade other options.

Covered calls are considered low-risk since the amount of money you can lose is limited. You can be exposed to theoretically unlimited risk with some other options contracts. "Covered calls can be a tremendous source of revenue," Henry Gorecki, CFP, told The Balance. "However, you should always be prepared to lose the underlying stock." "Think twice before writing calls on a great, expanding company's stock that you might want to own for long-term appreciation."

You're preventing yourself from losing money when using a covered call strategy. You're also limiting how much money you can make from a stock price rise. In exchange, you will receive cash in the form of the option buyer's premium.

Selling a call option usually is dangerous because it exposes the seller to unlimited losses if the stock rises in value. You can limit such potential losses and produce money by owning the underlying shares.

When the call option expires, one of two things will happen:

• If the stock closes above the striking price of the call, the call's worth is in the money, and the call buyer will purchase the stock from you at the strike price. 

• If the stock ends below the call's strike price, the call seller keeps both the stock and the option premium. The call buyer's option is worthless when it expires.

Example of a Covered Call

Here's an example of a covered call strategy in action. 

You've decided to buy 100 shares of ABC Corp. for $100 each. You feel that there will be less volatility in the stock market in the foreseeable future. You also forecast that ABC Corp.'s stock will rise to $105 in the following six months.

You sell a single call option contract with a certain amount of $105 that will expire in six months to lock in your profits (note that one call option contract consists of 100 shares). This call option has a premium of $3 per share in the contract.

The stock's price in six months will determine your future reward. You have three options:

Scenario 1: Stock price remains at $100 per share.

Because the call option is out-of-money in this case, the buyer will not exercise it (strike price exceeds the market price). You will not profit from the stock because the price will remain the same. On the other hand, the call premium will pay you $3 per share. 

Scenario 2: Stock price increases to $110.

The buyer will exercise the call option if the stock price rises to $110 per share after six months. You'll get $105 per share (the option's strike price) plus the call premium of $3 per share. You've given up a little of your prospective earnings in this covered call scenario in exchange for risk protection. 

Scenario 3: Stock price decreases to $90.

The call option will terminate in this situation as in scenario 1. The stock will lose $10 per share in value, but the $3 call premium will somewhat compensate for the loss. As a result, your total loss is $7 per share. 

Pros and Cons of a Covered Call

Pros 

1. Increase your income by selling covered calls: The buyer pays you a premium when you sell a covered call. This method can help you make money every time you sell a call if you want to make money from your portfolio.

2. Assist you in selecting your stock's target selling price: You can use covered calls to set a more excellent selling price compared with the current market price.

3. Compared to other riskier options trading strategies, losses are limited: Even if the stock sinks to zero. The shares become worthless in the worst-case scenario, and the loss is limited, unlike other options methods that may expose investors to permanent losses.

4. The premium obtained from the sale of a covered call might be used to supplement your income. As a result, many investors use covered calls. They have a regular schedule of selling covered calls — sometimes monthly, sometimes quarterly — to improve by a few percentage points annually.

5. Traders who trade covered calls may be capable of determining a stock's market value as more significant than the current price. For example, a 40 Call is sold for 0.90 per share, and stock is purchased for $39.30 per share. You will be paid the amount of $40.90, not even including commissions if the covered call is assigned, which implies the shares must be sold. An assignment will lead to a complete payment of $40.90 even if the stock price only rises to $40.50. Even if the stock price never hits that level, it's a good investment that the covered call can assist the investor in achieving his dream if he is prepared to sell at that price. 

6. Some investors may sell covered calls to provide a small degree of downside protection. In the case above, the $0.90 per share premium earned lowers the break-even point of owning this stock, lowering risk. However, because the premium obtained from selling a covered call is only a small percentage of the share value, the protection is quite minimal, if this can be called that.

7. When selling a covered call, the most you may profit is the premium and the differential between both the current stock price and the strike price. Even if the share's price rises over the strike price, you must still sell the stocks at the strike price.

8. While your options expire, you must continue to have the stock: You may require to liquidate some of your investments if your plans alter. To keep a call covered, you must own the stock until the option expires, which may require you to retain the stock for longer than you want.

9. Capital gains taxes apply to net gains: Depending on various conditions, you may be required to pay longer or shorter capital gains taxes.

Cons 

1. Limit the amount of money you could make if stock prices rise in the future: When selling a covered call, one of the most you may profit is the premium plus the difference between both the strike price and the current price per share. If the stock price rises over the strike price, you'll sometimes have to sell stock at the strike price.

2. When your options expire, you must maintain to own the stock: You may need to liquidate some of your investments if your plans alter. To keep a call covered, you must own the stock until the option expires, which may require you to retain the stock for longer than you want.

3. Capital gains taxes apply to net gains: Depending on a variety of conditions, you may be required to pay short-term or long-term taxes on capital gains.

4. If the stock price falls below, the true risk of losing money is below the breakeven point. The breakeven point is equal to the purchasing price of the shares minus the option premium received. Any stock ownership strategy comes with a large amount of risk. Even if stock prices merely fall to zero, the amount invested remains the same. Covered call investors must therefore be willing to incur stock market risk.

5. The risk of missing out on a significant increase in stock prices. As lengthy as the covered call is open, the covered call writer is engaged to selling the shares at the strike price. Even if the premium generates revenue above the strike price, it is limited. As a result, the covered call writer somehow doesn't profit totally if the stock price climbs above the strike price. Covered call writers frequently feel they "lost a fantastic chance" when the stock price rises significantly.

6. In exchange for the risk, there is a small, limited upside. With a covered call, you can gain a little money while also bearing the risk of the stock falling in value, resulting in a potentially unbalanced risk-return scenario.

7. All of the stock's upside has been traded away. One of the reasons you probably own the stock is its long-term growth potential. You can trade this upside until the option expires by setting up a covered call. If the stock rises, you will miss out on a potential profit.

8. Your stock may be "locked up" until the option expires. 

9. You may be hesitant to sell your stock until the call option expires if you sell a call option, albeit you could buy back the call option and then sell the shares.

10. It takes more money to get started. You'll need money to buy shares with a covered call, which is far more money than you'd need with a refine options strategy for a covered call. You may earn taxable money. 

11. In a taxable account, selling a successful covered call generates taxable income. Furthermore, suppose the underlying stock is called from you. It may result in an additional tax burden if the shares generated a capital gain.

When to Use a Covered Call?

A covered call is appropriate in a variety of situations, including the following:

• The stock isn't expected to move significantly. A trader does not want the price of a stock to climb over the option's strike price with a covered call until the option expires. It's also beneficial if the stock doesn't fall too far. You can still collect your premium and avoid losing any gains if the stock remains roughly flat.

• You're seeking a means to supplement your income from your current position. You can set up a covered call and produce money to take advantage of the comparatively high price of options premiums. It's essentially the same as creating dividends from stock.

• You're investing in a tax-deferred account. If you use covered calls to generate revenue, you risk having the stock called away, resulting in tax liabilities. Setting up covered calls in a tax-advantaged account like an IRA may be appealing because it allows you to avoid or defer paying taxes on these gains.

When to avoid a covered call?

In the following instances, a covered call should probably be avoided: 

You expect the stock to rise shortly. 

It makes little sense to give up a stock's potential upside for a small sum of money. 

If you believe a stock is primed to rise, you should generally hold on and let it do so. 

The stock has a significant downside. 

You might consider setting up a covered call after it has increased significantly. If you own a stock, you anticipate it to appreciate. However, don't utilize a covered call to try to profit from a company that appears to be headed for a major decrease in the near or long term. It's generally best to sell the stock and move on, or you might try to profit from its collapse by short-selling it.

Conclusion

A covered call, often known as a "buy-write," is a two-part strategy that, on a share-for-share basis, it entails purchasing stock and selling calls. In neutral to positive markets, covered calls can provide:

• Income.

• A selling price above the current market price in rising markets.

• A modest degree of downside protection.

Investors should also be satisfied with the estimated static and if-called returns provided they are:

• Willing to own the underlying asset.

• Willing to sell the stock at the effective price.

• Prepared to trade the stock at the effective price.

Cover calls lose money if the stock price falls below the breakeven point. There is also an opportunity risk if the stock price climbs over the covered call's effective selling price.

A covered call is a low-risk strategy to produce income from options, and it's popular among senior investors who don't want to sell their investments but want some income. With a covered call, you'll get a small profit in exchange for taking a small risk.