Covered calls are one way to make money off stock you own, by selling (or "writing") a call option that allows someone to buy it at a price you choose. In this way, you make money whether you sell it or not. It may seem like a sweet deal, but you need to understand the pros and cons of this stock trading strategy.
Basically, a covered call is where an options strategist buys stock in increments of 100 shares and for every 100 shares writes a call option contract against it. When the options strategist actually sells the call, they are giving somebody else the right to buy the stock at a fixed price. The word "covered" means the seller is not at risk if the stock climbs higher, as opposed to someone who sells uncovered or naked calls and can lose an unlimited amount if the stock moves higher. With covered call writing, this upside risk is eliminated, because you will always be able to deliver the shares no matter how high the stock climbs.
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How a Covered Call Option Works
The person who sells the covered call is known as the covered call investor. The person buying the call option is called the call option owner. The covered call can end in one of three ways:
• The share price can remain the same as the call option's exercise price during the exercise period.
• The share price can fall below the exercise price during the exercise period.
• The share price can rise above the exercise price during the exercise period.
For the first and second outcomes, the call option owner will let the call option expire unexercised because there is no profit in exercise, and the covered call investor can pocket the premium earned by writing the call option on the stock shares.
For the third outcome, the covered call investor must sell the stock shares to the call option owner because the option owner will exercise the call option unless something else prevents the purchase. For example, if a call option owner owns a call option with an exercise price of $25 and the shares are trading at $30, then the option owner may exercise the option because there is a profit of $5 on each share purchased at $25.
How to Use the Covered Call Strategy
Covered call writers usually fall into two different camps with two distinctly different objectives. The first is the strategist who wants to generate income against stock they plan to hold long-term. The other type employs the strategy for the sole objective of receiving high premiums. The more effective of the two covered call approaches is writing calls against stock you are willing to hold.
This income-seeking approach allows the investor to receive a little downside hedge and get paid to sell the stock at a price they see favorable. Assuming it is fundamentally superior stock and the investor likes it, then obviously they would be more apt to assume more downside risk. In essence, they would hold the stock whether options were available or not. Premiums earned on covered calls also help hedge part of the losses if the investor experiences an unexpected downswing in held share prices.
Call options can be sold in period after period so long as the investor can produce a rough estimate of future share prices and choose exercise prices for the call options accordingly. So long as the share price remains below the exercise price on the sold call options, the investor can continue to profit, though it is important to remember that other investors can see the same trends.
The less probable that the call options will be profitable, the less the premium earned on each such sale. Therefore, while an investor can earn a regular income on held stock shares in period after period, that income will be small but stable unless the investor can estimate the small band of possible future share prices with great accuracy. In that case, the investor's income will be higher but also much more uncertain due to possible unexpected upswings.
Those seeking high premiums set a premium price of 10 percent or more on the option for the stock in hopes someone will purchase it. These are often for more volatile stocks, because investors are willing to take bigger risk that the price will rise beyond what they purchase it from you for. Here, you are earning quick profit from stocks you don’t intend to hold for very long.
Risks of the Covered Call Strategy & How to Minimize Them
Investors can use the covered call to earn a premium income on their held shares even when share prices either fall or stay unchanged, but that does not mean the covered call is a risk-free strategy.
In practice, the covered call limits the investor's potential to cash in on the value of the stock itself. That investor cannot benefit from increases in the share price past the exercise price of the call option because the investor has sold that potential to the call option owner. Still, this needn't stop investors from earning premium income by writing call options on their held stock shares.
However, there are indeed risks in the covered call strategy. The position only covers you if the stock climbs through the strike price you sold the call at. It does not protect you from the losses incurred from a large drop in the underlying stock price. The covered call lowers the cost basis of the stock just by the amount of premium received. Any drop below that new cost basis would show up as losses to the position. This risk needs to be clearly understood by anybody wanting to use the covered call strategy.
The higher the volatility, the greater the risk, which is why high-premium covered calls should be done carefully after thoroughly researching the stock. If you have a high premium on a stock and no one takes you up on it before the prices fall, you will lose money.
Conclusion: Cover Your Calls with Careful Consideration
Covered calls can be an excellent way to make extra money on stocks you already own. By selling the premiums, you guarantee a sale at a price you set, or earn a premium if the call option is bought but never exercised. It has some risks, too. Before venturing into covered call options trading, be sure you have researched to stock to ensure its quality.