What is a covered call? - Brown Surfing

What is a covered call?

Posted on: July 7th, 2022
By: Efrain Lemus

The main idea behind a covered call is that you don’t expect the stock to move much in price. You expect it to stay within a range, what you own it at and the strike price you’re selling it at.

If the price of the stock goes above the strike price you sold, you will take ownership of the stocks (in hundreds).

Where the term comes from

The term covered call refers to a financial transaction in which the seller of call options has the same amount of the underlying security as the buyer. To produce an income stream, an investor who holds a long position in an asset sells call options on that asset to generate a revenue stream.

Because the investor is long in the asset, it serves as protection for the seller since if the buyer of the call option elects to exercise, he or she can deliver the shares.

What you need to know about covered calls

Covered calls are a balanced technique, which means the investor expects a minor movement in the underlying stock price for the life of the written call option. This strategy is frequently used by investors who have a short-term neutral viewpoint on an asset and who therefore hold it long while simultaneously establishing a short position via the option to make money from the premium.

If an investor does not expect a major price increase in the near term but intends to keep the underlying security for a long time, they can produce income (premiums) in their account while they wait.

A covered call is a short-term hedge on a long stock position and allows investors to profit from the premium received for selling the option. However, if the price rises above the option’s strike price, the investor loses portfolio gains. If the buyer exercises the option, they are required to deliver 100 shares at the strike price (for each contract written).

A covered call approach is not appropriate for traders who are very bearish or bullish. Extremely optimistic investors are typically advised to avoid writing the option and instead holding the stock.

The profit limit prevents the trader from making a bigger profit; if the stock price rises, it might lower the total return of the trade. Similarly, if an investor is very bearish, selling the stock may be preferable since the premium received for writing a call option will not compensate for any losses on the stock if it drops.

Factors to consider in a covered call

The maximum profit on a covered call is equal to the premium received plus the potential upside in the stock between the current price and strike price. As a result, if a $100 call is sold for $1.00 and the writer receives a premium of $1.00, the maximum possible profit is $1.00 + 10 percent appreciation in the stock.

The maximum loss is the purchase price of the underlying stock less the premium received, whereas the minimal loss is equal to the stock’s purchase price. This is because the stock may fall to zero, in which case you would only get back the premium for the options sold.

If an investor simultaneously purchases a stock and sells call options against it, it is known as a buy-write transaction.

Here’s an example of a covered call

Let’s pretend an investor owns shares in a hypothetical firm called JSX. Despite the fact that the investor believes the long-term prospects and share price are excellent, they anticipate that the stock will trade modestly lower in the near term, perhaps within a few dollars of its current price of $15.

If a trader sells a call option with a strike price of $25 on JSX, he or she makes money from the sale but is limited if the stock goes up to $25 for the duration of the option. Assume that writing a three-month call option costs them $1 ($100 per contract or 100 shares). One of two things will happen:

Let’s say JSX shares trade below the $25 strike price. The option expires worthless and you (the investor) keeps the premium received from the option contract. When you use the buy-write strategy successfully (like in this scenario) you become profitable. $100 in this case minus any broker fees.

If the JSX stock price rises above $25 the option gets exercised and the upside is capped at $25. If the price goes above $26 (this is the strike price plus premium) it would have been better to simply hold the stock without selling any call options against it. But if you planned to sell at $25 anyways, you would’ve received an extra $1 per share.

Is it profitable to do covered calls?

Covered calls are a type of option strategy for traders who want to take advantage of rising stock prices. Like all trading methods, covered calls may or may not be successful. If the stock price reaches the strike price of the sold call before it expires, the highest payoff from a covered call is realized.

The investor benefits from a minor increase in the stock price and receives the full premium of the option as it expires. Covered call writing, like any other method, has advantages and drawbacks. Covered calls may be a wonderful way to lower your overall cost or generate money if used correctly with the correct stock.

Is it risky to do covered calls?

Covered calls are thought to be a low-risk investment. But keep in mind that covered calls would prevent any additional gains in the stock price should it continue to rise and would not protect much against a significant drop in the price of the stock.

A call seller that does not own the same amount of underlying stock as the option is a naked writer, whereas a covered call seller has limited potential for loss. If the underlying security rises, a naked short call seller theoretically faces an infinite risk of loss.

When you would lose (sell) all your shares in a covered call

  • Let’s say you own 100 shares at $100 = $10,000
  • You sell a call at strike price $102
  • The price of the stock goes up to $102
  • $200 (capital gain) + premium
  • I lose (sold) all the shares

Technically, you don’t lose all your shares, but you sell them. So your profit is the $200 (capital gain) plus the premium received. And you get the $10,000 from selling the shares but you already owned that so it’s not a profit.

Can you use covered calls with your IRA?

Yes, in some cases. Depending on the IRA custodian and your option trading privileges with them, yes. There are several benefits to employing covered calls in an IRA. Covered call writing is a beneficial technique for either a conventional or Roth IRA because it has the potential to produce a reportable capital gain.

Investors can rest easy by purchasing back the stock at a fair price without having to worry about tax consequences, while also generating additional income that can be taken as distributions or reinvested.

Can you do covered puts?

Put options are a type of derivative that gives the contract holder the power to sell the underlying (rather than the option to buy it) at a predetermined price. A comparable position using puts might be selling short shares and then buying a put on the company’s stock.

Traders, on the other hand, frequently employ a married put to protect against stock price depreciation. An investor who holds a long position in a stock may buy a put option on it to guard against a price decrease.

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