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What Is a Covered Call?

Are you looking to generate consistent income for your family, even when the market isn’t doing much? Covered calls may be the perfect solution. This strategy allows you to generate income from selling call options, potentially even holding onto your stock long-term while collecting dividends and capital gains. Understanding the basics of this strategy, along with the advantages and drawbacks, can help you determine if it might be a good choice for you.

  • A covered call is a trading strategy that allows you to generate income on stocks that aren’t moving.
  • Covered calls help you minimize losses if the price of an underlying security drops.
  • Stock owners are obligated to sell the contracted shares of stock if the buyer chooses to exercise their option, even though they may have been hoping to hold onto the shares long-term.

What Is a Covered Call?

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A covered call is an options strategy that traders use when they think prices are unlikely to go up much in the near future. A call option is a contract that gives an investor the right, although not the obligation, to buy 100 shares of a particular stock at a specific price before the option expires.

If the investor selling the option owns the underlying security, it’s considered a covered call because they can deliver the shares without actually having to purchase them on the market. This means that the options seller, the writer, could avoid the risk of having to buy shares of stock if prices went really high.

A covered call is a strategy that an investor uses if they only expect a small increase or decrease in the shares of an underlying security for the life of the call option. They use this strategy by holding a long position in a particular stock while simultaneously selling call options on that stock in order to generate income from the premium the trader pays for the option. Simply put, selling a covered call lets an investor generate revenue from their account while they wait for a particular stock to increase in value.

Types of Stock Options

There are two types of stock options: calls and puts. If an investor believes that the price of a particular stock is going to go up on the open market, they typically buy a call option that lets them lock in a set price, the strike price, before the amount goes up. The call option becomes valuable as the price on the market rises above the strike price.

If an investor thinks that the price of a stock is going to go down, then they would buy a put option, which gives them the right to sell shares of a stock. In this case, the option becomes more valuable as the price on the open market goes down.

Exercising an Options Contract

When someone owns an options contract, they own the right to buy or sell shares of that stock before the option expires. If the option increases in value during that time and they choose to buy or sell those shares, it’s referred to as exercising their option. In other words, they’re putting into effect the right to buy or sell the stock that’s specified in the contract.

Benefits of Covered Calls

W hen you sell a call option, the investor who buys the option pays a premium for the right to purchase the shares at a specific strike price. That cash fee is the seller’s money to keep, regardless of whether the options trader exercises their option or not. That means that a covered call is most profitable when the price of the stock on the open market moves up to the strike price.

A covered call, therefore, allows the seller to generate profit from the long stock position, while the call option expires worthless. The seller collects the premium that the options trader paid for the call option, and they also get to hold onto the underlying security.

When you sell covered calls, you could potentially continue to collect dividends and capital gains. In fact, a covered call can feel like you’ve made a triple play, where you can collect the premium payment and still receive capital gains and dividends. However, you should be prepared because, as the ex-dividend date gets close, the buyer may exercise the option to collect the dividend for themselves. This is particularly likely if the option is in the money, where the market price is higher than the strike price.

Another benefit of selling covered calls is that you can offset a drop in stock prices. When the option expires out of the money (OTM), the profit from the short call offsets the loss in stock. With that said, if the price of your stock tanks, the cash you received from the premium offers only minimum protection from losses.

Drawbacks of Covered Calls

While a covered call works as a short-term hedge for investors who hold a long stock position, allowing them to earn income through the cash from the premiums, there are some drawbacks to covered calls. The most notable disadvantage is that they forfeit any gains if the price of the stock moves above the strike price. They’re also obligated to provide 100 shares at the strike price if the options trader decides to exercise their option. You can only profit on the covered call up to the strike price of the options contract.

Let’s say that you bought a stock at $8 and received a $0.10 premium from selling a call option with a strike price of $8.50. You can maintain your position if the price of the stock on the open market stays below $8.50. However, if the stock goes up in value to $10 on the market, you only can profit up to $8.50. This means that your profit would be $8.50 minus the $8 you originally paid for the stock plus the $0.10 premium payment, which comes out to $0.60 per share.

The most significant risk of a covered call occurs if the price of the stock goes to zero. For example, if you purchase a particular stock for $10 and receive a $0.15 option premium, the maximum loss is $9.85 per share. The cash you get for your premium reduces the maximum amount you can lose by owning the stock. To calculate the maximum loss per share, you would subtract the option premium received from the stock entry price.

Weighing the Risks and Benefits of Covered Calls

Ultimately, whether a covered call strategy is a good option depends on what you think the market is going to do. If you believe that the price of your stock is going to see a sudden spike, a covered call may not be appropriate because you’ll be forced to sell at the lower strike price. However, in markets where the prices are barely moving, covered calls could be a great strategy.

If the stock price goes up above the strike price, the buyer will most likely exercise the option. However, you should still see an overall profit, assuming the strike price is higher than the cost you originally paid for the stock. You may just be limiting your profits. If the cost of the stock moves near the strike price at expiration, you may end up being able to keep the stock and still retain the income from the now-worthless option.

One of the greatest drawbacks of covered calls is that you may be forced to sell a stock that you actually wanted to keep. Some traders hope that the option will expire so that they have the chance to sell a covered call again for further premium payments.

Like all types of investing, covered calls require you to weigh the risks versus the rewards. With the right strategy, selling options can be a fast way to generate tremendous returns on your portfolio. The key is to understand when you should be selling covered calls.