Covered call is a popular options trading strategy used by many investors to generate income on a stock that they already own. The covered call strategy involves selling call options against a stock that an investor holds in their portfolio. In this article, we will discuss in detail what the covered call trading strategy is, how it works, and the pros and cons of using it.
What is a Covered Call Trading Strategy?
A covered call is a trading strategy in which an investor sells a call option against a stock they already own. This is called a “covered” call because the investor owns the underlying stock, which acts as collateral against the call option they sold. By selling a call option, the investor receives a premium from the buyer of the option. This premium represents income for the investor, which can be used to supplement the returns generated by the stock they own.
How Does a Covered Call Trading Strategy Work?
When an investor sells a call option, they are agreeing to sell the underlying stock at a predetermined price (strike price) if the option buyer decides to exercise their option before the expiration date. If the stock price stays below the strike price, the option will expire worthless and the investor will keep the premium collected from the sale of the call option. If the stock price rises above the strike price, the option buyer will exercise the option and the investor will be obligated to sell their stock at the strike price. However, the investor will still keep the premium collected from the sale of the call option, which can help to offset any losses from selling the stock.
For example, let’s say an investor owns 100 shares of XYZ stock, which is currently trading at $50 per share. They decide to sell a call option with a strike price of $55 and an expiration date one month from now, for a premium of $2 per share. If the stock price stays below $55 until the expiration date, the option will expire worthless and the investor will keep the $200 premium. If the stock price rises above $55 and the option buyer decides to exercise their option, the investor will be obligated to sell their 100 shares of XYZ stock at $55 per share, but they will still keep the $200 premium collected from the sale of the call option.
Pros of Covered Call Trading Strategy
- Generates Income: The main advantage of the covered call trading strategy is that it generates income for investors. The premium collected from the sale of the call option can provide a steady stream of income, which can help to supplement the returns generated by the underlying stock.
- Limited Risk: The risk in a covered call trading strategy is limited because the investor already owns the underlying stock, which acts as collateral against the call option they sold. This means that if the stock price drops, the investor still owns the stock and can continue to hold it, while still keeping the premium collected from the sale of the call option.
- Flexibility: Covered call trading is a flexible strategy that can be used in a variety of market conditions. It can be used in both bullish and neutral markets, and can be adjusted based on the investor’s outlook for the underlying stock.
Cons of Covered Call Trading Strategy
- Limited Profit Potential: The covered call trading strategy limits the investor’s potential profit. If the stock price rises significantly above the strike price, the investor will be obligated to sell their stock at the strike price and will miss out on any additional gains. This is often referred to as “opportunity cost.”
- Downside Risk: While the risk in a covered call trading strategy is limited, it still exists. If the stock price drops significantly, the investor will experience losses in the underlying stock, which may not be fully offset by the Covered Call.
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