A covered call is an option strategy where an investor writes a call option for a stock that he already owns.
The covered call is a conservative but effective strategy that can be used to generate small profits. This article will explain everything there is to know about the covered call and give investors confidence to add this strategy to their investing playbook.
The covered call is used when an investor expects the underlying stock to have a slight increase or decrease in price. This is not a strategy to use when an investor is heavily bullish, or bearish.
By using this strategy, an investor walks away with a premium regardless of what happens to the underlying stock’s price. However, this strategy puts a cap on the stock’s profit potential.
Let’s look at an example to gain a better understanding.
Assume an investor owns shares of stock ABC. ABC is trading at $20. The investor sells a call option for ABC that expires in a month with a strike price of $23. The investor receives a premium of $2 per share for selling the option. However, he caps his potential upside on the stock at $23.
This example will play out in one of three scenarios:
- If ABC rises to $23 at expiration, then the call option will be exercised and the investor, who sold the call option, will be obligated to sell his shares of the stock. The investor will make $3 per share (23 – 20 = 3) plus the premium of $2 per share. If the investor was planning to sell the stock at $23, then this would be a good scenario as he profits an extra amount because of the premium.
- If ABC rises to $30 at expiration, then the call option will be exercised and the investor, who sold the call option, will be obligated to sell his shares of the stock. He would sell the shares at $23, thus giving him a profit of $3 per share plus the premium of $2 per share. However, if he did not sell a call option for this stock, then he would still be the owner of the stock when its price was $30. That is a profit of $10 per share. By selling the call option, the investor put a cap on the potential profit he could have made.
- If ABC falls to $19, then the option would expire worthless. The investor, who sold the call option, still gets $2 per share for the premium. However, he loses $1 per share because of the stock’s price fall. The premium helps offset the loss in stock price.
These three scenarios show the possible results of executing the covered call strategy. An investor will get his best result from the strategy if the stock price remains relatively neutral. If this happens, the investor walks away with the premium while still owning shares of the stock.
The covered call is a safe and effective strategy that investors can use to earn small profits in option trading.