Covered Call

A covered call is an options strategy used by investors to generate additional income from stocks they already own. It involves selling a call option on a stock or asset that the investor owns, "covering" the call with the underlying asset.

How It Works:

  1. Own the Underlying Asset: The investor must already own the stock or asset. For each call option sold, they typically need 100 shares of the stock (since one option contract usually represents 100 shares).

  2. Sell a Call Option: The investor writes (sells) a call option, agreeing to sell the stock at a specified strike price if the buyer of the option chooses to exercise it.

  3. Collect the Premium: The investor receives an upfront premium from the buyer of the call option. This premium is the income generated by the strategy.

Outcomes:

  • Stock Price Below Strike Price: The call option expires worthless. The investor keeps the premium as profit and retains ownership of the stock.

  • Stock Price Above Strike Price: The call option is exercised, and the investor is obligated to sell the stock at the strike price. While the investor may miss out on some upside potential beyond the strike price, they still keep the premium and the gains up to the strike price.

Example:

  1. You own 100 shares of stock ABC, currently trading at $50.
  2. You sell a call option with a strike price of 55,expiringinonemonth,fora55, expiring in one month, for a 2 premium per share.
  3. Possible scenarios:
    • If ABC stays below 55,theoptionexpiresworthless,andyoukeepthe55, the option expires worthless, and you keep the 200 premium and your stock.
    • If ABC rises above 55,thebuyerexercisestheoption,andyousellyourstockat55, the buyer exercises the option, and you sell your stock at 55, keeping the 200premiumandanygainsupto200 premium and any gains up to 55.

Benefits:

  • Generates income from the premium.
  • Provides a small hedge against downside risk (from the premium collected).

Risks:

  • Limited upside: Gains are capped at the strike price plus the premium.
  • Full downside risk: If the stock's price falls significantly, losses on the stock may outweigh the premium collected.

A covered call works best for investors who are neutral to moderately bullish on the underlying stock.