Generally, the covered call is one of the simplest and most regularly used options-based techniques for investors pursuing income as a strategy to increase profits potentially. Traders and investors may choose to explore covered call options for their IRAs. It is a simple options strategy, but there are a few things of a covered call to keep in mind.
List of Contents
What Exactly Is a Covered Call?
A covered call is a type of strategy used in options trading. It provides a limited return in exchange for a limited amount of risk. When you sell a call option on a stock you already own, this strategy is known as a “covered call.” If the stock goes up and the call option is still in the money when it expires, you are “covered.” This means you are protected because you own the shares. Significantly, a covered call is one of the option strategies with reduced risk, and it is appropriate for beginner option investors because of its accessibility.
Working Principles of Covered Call
A covered call is a simple options strategy in which you sell a call option for every 100 shares of the underlying stock you possess. It is a straightforward options trading that generates revenue from a stock holding.
A covered call is a hedging strategy in which the trader sells a portion of the stock’s upside for a set period in exchange for the option premium. Notably, selling a call option is usually dangerous as it exposes the seller to unlimited losses if the stock climbs. However, holding the underlying stock can restrict your potential losses while also earning money.
For example, ABC is currently trading at $20 per share, and a three-month call option with a strike price of $20 will expire in three months and costs $1. The contract’s premium is $100, or $1 multiplied by one contract multiplied by 100 shares per contract. A covered call is executed when an investor purchases 100 shares of ABC for $2,000 and then sells one call for $100.
When the call option expires, one of two things will happen:
- If the stock closes above the call’s striking price, the call buyer buys the stock from you at the strike price. The call seller retains the option premium.
- If the stock closes below the call’s strike price, the call seller keeps both the stock and the option premium. The call buyer’s option is worthless when it expires.
The Example of the Covered Call
Here are the profit and loss figures for the covered call’s various components:
In this instance, the covered call trader breaks even on the absolute position at $19 per share. That is the $20 stock price minus the $1 received premium. At stock prices lower than that, the trader loses money greater than the $1 premium gained. If the stock price at expiration is less than $20, the trader retains the stock and includes the entire premium.
At a stock price of $20 at expiration, the trader would retain the total $1 premium, and the call buyer would typically not exercise the option. Therefore, the investor earns $100 at the current stock price.
At stock values above $20 at expiration, the maximum gain for the trader is $100. At the same time, the short call option loses $100 for each $1 increase in the stock’s price over $20. The stock’s gain completely offsets this loss. Consequently, the maximum profit for the trader is $100, the original premium obtained. In this example, the trader loses all possible stock earnings over $20 per share.
In every covered call, the maximum gain is limited to the option premium, regardless of the stock’s movement. While it is impossible to earn more, it is possible to lose more. Even if the share price falls to $0, the premium will be the sole positive outcome. In this scenario, you would get $100 on the option premium but lose $2,000 on the stock, resulting in a net loss of $1,900. If the stock fell significantly, you could repurchase the call option at a lower price and then sell the stock position if desired.
The Benefits And Drawbacks of a Covered Call
Covered calls can be an attractive options strategy for a variety of reasons. However, like with all options strategies, they also have their drawbacks.
Benefits
- Provides income through a position
- Comparatively low danger
- Simple to set up
- Hedges your risk
- Can be reestablished repeatedly
Drawbacks
- Minimal upward potential in exchange for downside risk
- Trading away the entire upside of the stock
- Your stock may be locked up until option expiration.
- Requires more capital to set up
- Possible to generate taxable income
Benefits of a Covered Call
- Provides income through a position
A covered call can provide money from an investment in a stock that may or may not pay a dividend, enhancing its overall profitability.
- Comparatively low danger
A covered call is a relatively low-risk strategy of trading options, as your stock position protects the short call.
- Simple to set up
A covered call position is likewise extremely simple to establish. It is essential to purchasing the stock before selling the call.
- Hedges your risk
A covered call mitigates the risk associated with an investment by providing compensation.
- Can be reestablished repeatedly
If the call expires without value and you retain your shares, you can establish it again. Even if your shares are called away, you can repurchase them and establish another of it.
Drawbacks of a Covered Call
- Minimal upward potential in exchange for downside risk
With a covered call, you can make a modest amount of money but also suffer any stock losses. It results in a potentially unbalanced risk-reward profile.
- Trading away the entire upside of the stock
The stock’s potential for long-term growth is probably one of the reasons you purchase it. By establishing a covered call, you are trading the option’s upside until its expiration. If the stock price rises, you forfeit a potential profit.
- Your stock may be locked up until option expiration.
By selling a call option, you may be hesitant to sell your shares until the option expires. However, you might repurchase the call option and then sell the stock.
- Requires more capital to set up
With a covered call, you will need money to purchase shares, which requires far more cash than a pure options strategy.
- Possible to generate taxable income
In a taxable account, the sale of a successful covered call will create taxable income. In addition, if you earned a capital gain on the underlying stock, you may incur additional tax liabilities if the stock is called away from you.
When to Use a Covered Call?
- You need to earn money from a position.
If you need to profit from the comparatively high cost of options premiums, you might establish a covered call and make money. Essentially, it is the same as generating a dividend from a stock.
- You are trading through a tax-favored account.
When employing this strategy, you generate revenue, and the stock may be called away, resulting in tax liabilities. Setting up covered calls within a tax-advantaged account, such as an IRA, may be advantageous. This is because it allows you to avoid or defer taxes on these gains.
When to Avoid a Covered Call?
- You forecast a stock price increase shortly.
Giving up a stock’s prospective appreciation for a modest sum of money makes little sense. If you believe a stock is likely to rise, you should hold on and let it grow. Then, once it has increased significantly, you can consider placing the covered call.
- The stock has a substantial downside.
If you own a stock, you often anticipate its price to rise. However, you should not utilize a covered call to try to generate additional income from a company that is likely to decline dramatically in the near or distant future. You should probably sell the stock and move on, or you may attempt to short-sell it and profit from its drop.
Conclusion
In short, a covered call can be a relatively low-risk strategy to produce income with options. Moreover, it is popular among senior investors who don’t want to sell their investments but need income. With a covered call, you will receive a restricted return in exchange for typically little risk.
FAQs
A covered call is an options trading strategy in which an investor holds a long position in an asset and sells a call option on that same asset.
By selling a call option, the investor receives a premium, which can generate income. If the underlying asset’s price remains below the strike price of the call option, the investor keeps the premium and can repeat the process.
A covered call strategy is suitable when the investor believes the asset’s price will remain relatively stable or increase slightly.
An investor can manage risk in a Covered Call strategy by setting a stop-loss order to limit potential losses if the asset’s price drops significantly.
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Source: Bankrate