A covered call allows equity investors to generate income from their stock holdings by combining stock ownership with the sale of call options on the same underlying equities.
A covered call is executed by holding a long position in a stock and then selling a call option on that same stock. The “covered” part of the term signifies that the seller owns the underlying stock on which the call option is sold, hence able to deliver the shares should the option buyer choose to exercise their right to buy the stock.
Here’s how it works: an investor sells call options for the stocks they own, receiving a premium from the buyer of the option. If the stock price remains below the strike price of the call option until expiration, the option expires worthless, and the seller retains the premium as profit. However, if the stock price exceeds the strike price, the option may be exercised by the buyer, obligating the seller to sell the stock at the strike price, regardless of current market value.
Pros of Covered Call Strategy:
Income Generation: The premium received from selling the call option provides an immediate return on investment, which can be a steady income stream.
Downside Protection: The premium also offers a limited cushion against stock price declines, effectively lowering the breakeven point of the stock investment.
Flexibility: The strategy can be tailored with different strike prices and expiration dates to suit the investor’s risk tolerance and market outlook.
Cons of Covered Call Strategy:
Capped Upside Potential: If the stock price surges above the strike price, the seller misses out on any gains above this level, as the stock will be called away.
Risk of Decline: While the premium provides some protection, it does not shield against significant stock price drops; losses can still occur.
Opportunity Cost: The investor is obligated to sell the stock if the option is exercised, which might prevent them from realizing potential gains if the stock price continues to climb after the sale.
Example
For example, an investor holds 100 shares of a company priced at $50 each. They sell one call option with a strike price of $55 for a premium of $2 per share. If the stock price stays under $55, the investor keeps the premium and the shares. If the stock price rises above $55 and the option is exercised, the investor must sell the stock at $55, but they still profit from the premium and the $5 gain per share over their stock purchase price.
Covered Call Diagram
The covered call strategy is particularly favoured by investors looking to boost income while maintaining a measure of control over their stock positions, reflecting a moderate, income-focused investment approach.
