What Is A Covered Call?
A covered call is an options trading strategy when an investor created a buy position in an underlying asset and simultaneously sells a call option of an equivalent quantity of the same underlying asset. The underlying asset can be stocks, currencies, commodities, or other financial Instruments.
Investors implement this strategy to limit its loss and take benefit from a side-wise market movement.
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Explanation of Covered Call Option Strategy
Using Covered call option strategy investors generally makes money by selling a call option and buying the stock in a side-wise to neutral market movement and some use it for hedging purpose.
On a neutral to side-wise market, investors generally create a short position in out of the money call option, where the strike price is higher than the stock price. In this way, if the stock stays right there or increase a little bit, they can get profit in both scenarios. In the time of expiry they will receive a premium and also gain in the stock.
If investors think the market will go downwards, then they may create an in the money call option to limit the stock loss and receive a higher premium on the call option.
Suppose there is the stock trading at $96, with a lot size of 100. An investor created a long position in the stock at $96 and shorted a 100 strike price call option at $3 expecting a neutral-bullish market. So using this strategy here is the potential gain or loss:
Maximum Profit = ( Strike Price – Stock Entry Price) + Option Premium Received
In an ideal scenario, during expiry if the stock price equals $100 then gain in the stock will be $4, and the option will be exercised at $0 so gain will be $3. So total maximum gain would be $7 multiplied by 100 equals $700.
Maximum Loss Per Share = Stock Entry Price – Option Premium Received
Maximum loss using this strategy is quite complicated as it depends upon the fall in stock price. So maximum loss would befall in stock price minus the option premium investor will receive.
Break-Even Point = Stock Price At The Time of Buying – Option Premium Received
Break-even point for investors would be stock price minus the option premium received; $96 – $3 = $93.
Advantages of Covered Calls
- Selling call options in a covered call strategy can help to limit the downside risk or add to upside return on stock by receiving the premium.
- In an ideal scenario it can be highly profitable because of that, it is famous among the investors.
Risk Involved In Covered Call Option Strategy
When stock price changes, it is always not the case that the call option will rise dollar to the dollar as the stock price increases. The option pricing depends upon various factors like volatility and time value.
if the volatility of a stock increases significantly, then the sold option can incur higher loss than the stock as an option price known to rise higher than the stock when volatility increases.
Suppose a stock price reduced to its half, then investors may suffer huge losses as they are holding the stock, but the option premium they will receive is limited and can not cover their loss.
The main investment goal of the covered call option strategy is to receive the earning while receiving the option premiums by selling call option against a stock you bought. Assuming a side-wise market and the stock doesn’t move above the strike price, you will receive the option premium and maintain your stock position in holdings.
Investors should also consider the brokerage factor when trading covered calls. If the brokerage is higher and weighs a significant portion of the premium received then it isn’t worth creating a covered call option strategy.