What is a Covered Call Option Strategy?
Options allow investors to control a certain amount of stock without owning it. A covered call is an option strategy that involves selling shares you already own and then writing call options on those same shares simultaneously. While they can be complex, there are several benefits to this strategy.
What Is a Covered Call?
So, what is a covered call? A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. Investors can turn their existing assets into more money without moving beyond their current investment choices. As per the experts at tastytrade, “The long stock position limits the profit potential of a long stock position by selling a call option against the shares.”
Options give you this kind of flexibility, which is why they can be so valuable in your portfolio. Stocks have two primary uses for options: buying them for protection and selling them for profit. Covered call options are the latter example, which creates a covered option strategy.
Profiting from Covered Calls
The basic idea of this method is that it allows you to turn your current holdings into extra income without selling your stock. It also eliminates any additional risk other than what already exists in owning stocks.
If you are familiar with options, you know that they are a contract between two parties. In this case, the buyer of the call option is buying the right to purchase shares from the seller at a specific price (the strike price) during a certain period.
The beauty of this strategy is that it caps your profit potential while also providing some downside protection. It restricts your profit by limiting it to the premium you receive.
The downside protection comes into play if the stock value drops below this strike price at any point during that period. Under these circumstances, you are still obligated to sell the shares at the strike price, meaning there is no loss beyond what already exists in owning them.
When to Sell a Covered Call?
There are a few things to keep in mind when determining when to sell a covered call. The most important factor is the stock’s current price. You want to make sure that you sell the option for more than its intrinsic value. This means that the premium you receive should be greater than the amount of money you would make if you just held on to the stock.
You’ll also want to consider how long you have until the option expires. The further out it is, the less likely the stock will be above the strike price by then. Finally, it would be best if you think about volatility. If it’s high, there’s a greater chance that the stock could move significantly before the option expires.
Risks Of a Covered Call
Like any other investment decision, there are risks involved with covered calls. The most obvious is that the stock could go down in value, and you would be forced to sell at a loss. Additionally, if the buyer exercises the option, you will have to sell your shares at the strike price, even below the current market value. This could be an opportunity cost if the stock continues to rise after you sell it.
Finally, some risk goes along with writing options in general beyond just covered calls. If the option expires without being exercised (meaning bought by someone else), then you will lose all of your investment capital for good.
Conclusively, covered calls can be a great way to generate some extra income from your current stock holdings. However, it’s crucial to weigh all the risks and rewards before deciding. There is no guarantee that you will make money as with any investment. However, if done correctly, this strategy can help smooth out the bumps in the road and provide some extra income.
