Covered Call

Definition

A covered call is an options trading strategy where an investor sells call options on an asset they already own. This strategy allows the investor to generate additional income from the premiums received for selling the call options while still holding the underlying asset. It is often used when an investor believes that the asset price will remain stable or rise moderately over the short term.

5 Must Know Facts For Your Next Test

1. A covered call is considered a conservative strategy because it provides downside protection through the premium income while still allowing for some capital gains on the underlying asset.
2. If the price of the underlying asset rises above the strike price of the sold call option, the investor may have to sell their shares at that price, potentially missing out on further gains.
3. This strategy is particularly effective in flat or slightly bullish markets, where the investor wants to enhance returns on their stock holdings without taking on significant risk.
4. Investors should choose a strike price for the call option that aligns with their market outlook and risk tolerance, balancing potential gains with the likelihood of having to sell their shares.
5. The maximum profit from a covered call occurs when the stock price rises to the strike price and is sold at expiration, which includes both the premium received and any gains from selling the stock.

Review Questions

• How does a covered call strategy benefit an investor in a flat or slightly bullish market?
  • In a flat or slightly bullish market, a covered call strategy allows an investor to generate additional income through premiums while holding onto their underlying asset. This is beneficial because it enhances returns without needing significant price appreciation. The investor still has potential upside if the asset's price increases moderately, while also gaining some downside protection from the premiums collected.
• What are some risks associated with using a covered call strategy, particularly in relation to market movements?
  • One major risk of employing a covered call strategy is that if the underlying asset's price rises significantly above the strike price of the sold call option, the investor must sell their shares at that strike price. This can lead to missed opportunities for greater profits if they would have preferred to hold onto their shares for larger gains. Additionally, if the market declines, while premiums offer some cushion, losses on the underlying asset can still be significant.
• Evaluate how selecting different strike prices for sold call options can impact an investor's overall investment strategy when using covered calls.
  • Selecting different strike prices affects both potential profit and risk exposure in a covered call strategy. A higher strike price may result in lower premiums but allows for more upside potential if the stock rises. Conversely, a lower strike price offers higher premiums but increases the likelihood of having to sell shares at a lower price than desired. Investors must weigh their risk tolerance and market expectations when deciding on strike prices, as this choice ultimately shapes their income generation and capital appreciation strategies.

Related terms

Call Option: A financial contract that gives the buyer the right, but not the obligation, to purchase an underlying asset at a specified price before a certain date.

Premium: The price paid by the buyer of an option to the seller, which is received as income by the seller when writing the option.

Underlying Asset: The financial instrument, such as stock or commodity, upon which an option's value is based.