Covered call is a popular options trading strategy used by investors to generate income on their portfolio. It is a relatively low-risk strategy that involves selling a call option on a stock that the investor already owns. In this article, we will discuss what a covered call is, how it works, and how to trade it.
What
is a Covered Call?
A covered call is a strategy
where an investor sells a call option on a stock that they already own. The
call option gives the buyer the right, but not the obligation, to buy the stock
at a specific price, known as the strike price, on or before a specific date,
known as the expiration date. The investor, who is also known as the writer of
the call option, receives a premium in exchange for selling the call option.
How
Does a Covered Call Work?
A covered call works by
combining two positions: a long position in a stock and a short position in a
call option. The investor who owns the stock sells a call option at a strike
price above the current market price of the stock. This creates an obligation
for the investor to sell the stock to the buyer of the call option at the
strike price if the buyer decides to exercise the option.
If the stock price remains
below the strike price of the call option, the option will expire worthless,
and the investor keeps the premium received from selling the option. If the
stock price rises above the strike price, the buyer of the option may exercise
the option, and the investor will be obligated to sell the stock at the strike
price. In this case, the investor will make a profit on the stock sale, but
this profit will be limited to the strike price plus the premium received from
selling the option.
For example, let's say an
investor owns 100 shares of ABC stock, which is currently trading at $50 per
share. The investor sells a call option with a strike price of $55 and receives
a premium of $2 per share. If the stock price remains below $55 by the expiration
date, the option will expire worthless, and the investor keeps the $200
premium. If the stock price rises to $60, the buyer of the option may exercise
the option, and the investor will be obligated to sell the stock at $55 per
share. In this case, the investor will make a profit of $5 per share on the
stock sale, plus the $2 premium received from selling the option.
How
to Trade a Covered Call?
To trade a covered call, an
investor must first own the underlying stock. The investor can then sell a call
option on the stock by selecting the strike price and expiration date of the
option. The investor receives a premium for selling the option, which can
provide income on their portfolio.
There are several factors to
consider when trading a covered call, such as the strike price, expiration
date, and the premium received from selling the option. The strike price should
be chosen carefully, as it will determine the potential profit on the stock
sale if the option is exercised. The expiration date should also be considered,
as a longer expiration date may provide more time for the stock price to rise
above the strike price, but may also result in a lower premium.
Conclusion
A covered call is a popular
options trading strategy that can provide income on an investor's portfolio. It
involves selling a call option on a stock that the investor already owns,
creating an obligation to sell the stock at a specific price if the option is
exercised. A covered call can be a low-risk strategy, but it requires careful
consideration of the strike price and expiration date of the option. Investors
who are interested in trading covered calls should research the strategy thoroughly
and consult with a financial advisor before investing.