Options and other derivatives trading and investment need a high degree of prudence. The main reason is that trading options are much riskier than buying common stock. Because of the potential for gains and losses, most seasoned investors use options trading tactics designed to reduce the former.
Expert traders and investors routinely employ a covered call method when trading options. If you're unfamiliar with the term "covered call option strategy," let me explain!
What Is A Covered Call?
When you engage in the financial strategy known as a covered call expiration date, you do so when you sell another party the right to acquire shares of a stock you already own. Hence the term covered, at a predetermined price, the strike price at any time on or before a given date. It is the definition of a covered call.
The amount you receive in exchange is known as a premium, and you get to keep this payment regardless of whether or not the call is exercised. Consequently, covered calls can effectively produce revenue even in markets heading only slightly upward.
If the underlying stock price rises higher than the call option's strike price, the covered call buyer can. If this occurs, you would be required to give up any gains on the underlying stock above the strike price. However, the premium you were given compensates you for part of the risk of lost profits and compensates for some of the risks of a more modest loss.
The most favorable outcome for this approach would be for the stock price to experience a moderate appreciation. It would result in a moderate profit from the stock's appreciation and some premium income from the call option.
How Does A Covered Call Work?
A covered call is a fundamental options strategy that entails selling a call option or going short, as the industry professionals refer to it, for every 100 shares of the underlying company that the investor already possesses. Setting up this options strategy, which results in income from stock investment, may be done quickly.
A covered call is a hedged strategy in which the trader sells some of the stock's upside for some time in return for the option premium. It is done to reduce the risk to which the trader is exposed. Selling a call option is typically considered a high-risk activity since it exposes the seller to potentially limitless losses if the underlying stock price increases. On the other hand, having the underlying stock protects you from such possible losses and allows you to produce money.
Two possible outcomes could take place once the call option has expired: If the stock's final price is higher than the call's strike price—that is, the price at which the option becomes profitable—then the buyer of the call option will buy the stock from you at the strike price. The call seller retains the option premium that was paid. If the stock closes at a low price than the call's strike price, the person who sold the call gets to keep both the stock and the option premium. The buyer's call option will become worthless after it has expired.
Covered Call Strategy Without The Stock
In this version of the covered call strategy, rather than purchasing 100 shares of stock and then selling a call option, Rather than holding shares, the trader buys a call option with a longer expiration date and increases his overall option position while decreasing his stock holdings. In other words, the trader buys more options than he generates revenue from selling call options.
The result is a position that is effectively a calendar spread. It is another name for the position. When compared to a standard covered call position, this position has the potential to offer several advantages, including the following: There is a possibility of a larger percentage rate of return, there is less risk associated with the possibility of profit, and there is a significantly lower cost to enter a trade.
Advantages Of A Covered Call
The following are some of the advantages that come with using covered calls:
- To assist you in determining a desired selling price for the stock you own: You can target a selling price greater than the current market price when you use covered calls.
- You can generate additional money from the shares you already own by selling covered calls and collecting the premium that the buyer of the call pays. If you want to generate income from your portfolio, implementing this method can help you turn each sale of a call into additional revenue.
- Losses are limited compared to other options trading strategies that involve a higher level of risk: Although the stock price collapses to zero and the value of the shares are destroyed, the loss is still limited. It contrasts other options techniques, which could put investors at risk of incurring losses without limit.
Disadvantages Of A Covered Call: Reasons Not To Trade Covered Calls
Below are some of the issues that can arise from using a covered call:
- You are obligated to maintain your stock holdings until your option expires: Some people decide to liquidate their investments when their plans change. To keep a call covered, you must have the shares in your possession until the option expires. It could result in you holding on to the shares for longer than you would prefer.
- Curb your potential profits from stock price increases in the future: You can earn up to the sum of the premium received and the spread between the strike price and the current price per share by selling covered calls. Even if the share's price rises over the strike price, you'll still be required to sell them at that price.
Conclusion:
It is possible to produce money via the use of options in a low-risk manner with the assistance of a strategy known as a covered call. This approach is particularly popular among more experienced investors who do not need to liquidate their positions but would still like to generate revenue. A covered call enables you to generate a modest profit from your investment while exposing you to a more tolerable risk level.
