The Basics of Covered Calls

professional market players write covered calls to boost investment income, but individual investors can besides benefit from this conservative but effective option scheme by taking the time to learn how it works and when to use it. In this involve, let ‘s expect at the breed call and test ways it can lower portfolio risk and improve investment returns .

Key Takeaways

  • A covered call is a popular options strategy used to generate income from investors who think stock prices are unlikely to rise much further in the near-term.
  • A covered call is constructed by holding a long position in a stock and then selling (writing) call options on that same asset, representing the same size as the underlying long position.
  • A covered call will limit the investor’s potential upside profit, and will also not offer much protection if the price of the stock drops.


Covered Call

What Is a Covered Call ?

You are entitled to several rights as a stock or futures contract owner, including the right to sell the security at any fourth dimension for the commercialize monetary value. Covered call writing sells this correct to person else in exchange for cash, meaning the buyer of the option gets the right to own your security on or before the passing date at a preset price called the come to price .

A call option is a contract that gives the buyer the legal right ( but not the obligation ) to buy 100 shares of the underlying stock or one futures compress at the assume price any clock time on or before termination. If the seller of the call choice besides owns the underlie security system, the option is considered “ covered ” because they can deliver the instrument without purchasing it on the open market at possibly unfavorable price .

Profiting from Covered Calls

The buyer pays the seller of the predict option a agio to obtain the right to buy shares or contracts at a preset future monetary value. The bounty is a cash fee paid on the day the choice is sold and is the seller ‘s money to keep, careless of whether the option is exercised or not. A cover birdcall is consequently most profitable if the stock moves improving to the strike price, generating profit from the long stock position, while the call that was sold expires despicable, allowing the call writer to collect the integral premium from its sale .

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When to Sell a Covered call

When you sell a cover call, you get paid in rally for giving up a dowry of future top. For model, let ‘s assume you buy XYZ stock for $ 50 per share, believing it will rise to $ 60 within one year. You ‘re besides willing to sell at $ 55 within six months, giving up far top while taking a short-run profit. In this scenario, selling a covered bid on the status might be an attractive scheme .

The stock ‘s option chain indicates that selling a $ 55 six-month predict choice will cost the buyer a $ 4 per share premium. You could sell that option against your shares, which you purchased at $ 50 and hope to sell at $ 60 within a class. Writing this embrace call creates an obligation to sell the shares at $ 55 within six months if the fundamental price reaches that floor. You get to keep the $ 4 in premium plus the $ 55 from the parcel sale, for the grand piano total of $ 59, or an 18 % return over six months .

On the other hired hand, you ‘ll incur a $ 10 loss on the original side if the stock falls to $ 40. however, you get to keep the $ 4 agio from the sale of the call option, lowering the sum personnel casualty from $ 10 to $ 6 per plowshare .

Bullish Scenario: Shares Rise to $60 and the Option Is Exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $60 – option is exercised because it is above $55 and you receive $55 for your shares.
July 1 PROFIT: $5 capital gain + $4 premium collected from sale of the option = $9 per share or 18%
Bearish Scenario: Shares Drop to $40 and the Option Is Not Exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $40 – option is not exercised and it expires worthless because stock is below strike price. (the option buyer has no incentive to pay $55/share when they can purchase the stock at $40)
July 1 LOSS: $10 share loss – $4 premium collected from sale of the option = $6 or -12%. 

Advantages of Covered Calls

Selling covered call options can help offset downside hazard or add to upside return, taking the cash premium in central for future top beyond the rap monetary value plus premium during the contract period. In other words, if XYZ breed in the model closes above $ 59, the seller earns less return than if they just held the breed. however, if the stock ends the six-month period below $ 59 per share, the seller makes more money or loses less money than if the options sale had n’t taken invest .

Risks of Covered Calls

call sellers have to hold onto underlying shares or contracts or they ‘ll be holding naked calls, which have theoretically inexhaustible loss potential if the underlying security system rises. consequently, sellers need to buy back options positions before termination if they want to sell shares or contracts, increasing transaction costs while lowering final gains or increasing final losses .

What Are the Main Benefits of a Covered Call?

The independent benefits of a cover address scheme are that it can generate premium income and boost investment returns, and help investors target a sell price that is above the stream market price .

What Are the Main Drawbacks of a Covered Call?

The chief drawbacks of a cover call strategy are the risk of losing money if the malcolm stock plummets ( in which casing the investor would have been better off selling the standard outright quite than using a cover call scheme ), and the opportunity price of having the stock “ called ” away and forgoing any significant future gains in it .

Is There a Risk If I Sell the Underlying Stock Before the Covered Call Expires?

Yes, this can be a huge risk, since selling the underlying banal before the traverse visit expires would result in the call now being “ naked “ as the lineage is nobelium long owned. This is akin to a short sale and can generate outright losses in hypothesis .

Should I Write a Covered Call on a Core Stock Position with Large Unrealized Gains That I Wish to Hold for the Long Term?

It might not be advisable to do therefore, since selling the sprout may trigger a significant tax liability. In addition, if the sprout is a kernel position that you wish to hold for the long term, you might not be excessively happy if it is called away .

The Bottom Line

Use covered calls to decrease the cost basis or to gain income from shares or futures contracts, adding a profit generator to stock or contract possession .

Like any strategy, covered call writing has advantages and disadvantages. If used with the right field stock, covered calls can be a great way to reduce your average cost or generate income .

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