Covered call

Definition

A covered call is an options strategy where an investor holds a long position in an asset and simultaneously sells call options on that same asset. This strategy is often used to generate additional income from the premiums received from selling the call options while also providing some downside protection. Investors who employ this strategy typically have a neutral to slightly bullish outlook on the underlying asset.

5 Must Know Facts For Your Next Test

1. The covered call strategy can enhance returns by generating income through option premiums while still maintaining ownership of the underlying asset.
2. If the asset's price exceeds the strike price of the sold call option, the investor may have to sell the asset at that price, potentially missing out on further gains.
3. This strategy works best in sideways or moderately bullish markets where significant price increases in the underlying asset are not expected.
4. Investors can use covered calls as a way to mitigate losses in a declining market since the premium collected provides some cushion against depreciation.
5. Covered calls are popular among income-seeking investors, especially those holding stocks in their portfolios, as they add an extra layer of cash flow.

Review Questions

• How does selling call options while holding the underlying asset benefit an investor using a covered call strategy?
  • Selling call options while holding the underlying asset allows an investor to generate additional income through the premiums received. This income can provide a buffer against potential declines in the asset's value. Additionally, if the price of the underlying asset remains stable or increases moderately, the investor can benefit from both the premium and any capital appreciation in the stock.
• What are some potential risks associated with employing a covered call strategy, particularly in relation to market movements?
  • One major risk of using 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 will have to sell their shares at that strike price, potentially missing out on higher profits. Conversely, if the market declines sharply, while premiums offer some protection, they may not fully offset losses incurred from holding the underlying asset. This creates a trade-off between income generation and profit maximization.
• Evaluate how market conditions influence an investor's decision to implement a covered call strategy and its effectiveness in different market environments.
  • Market conditions play a crucial role in determining whether a covered call strategy is appropriate. In stable or moderately bullish markets, this strategy can be highly effective as it generates additional income while still allowing for potential capital gains. However, in bearish or highly volatile markets, it may limit upside potential since rising prices can lead to share sales at lower than optimal prices. An investor must assess their market outlook and risk tolerance when deciding to implement this strategy for it to align with their investment goals.

Related terms

call option: A financial contract that gives the holder the right, but not the obligation, to buy an underlying asset at a specified price within a specified time frame.

put option: A financial contract that gives the holder the right, but not the obligation, to sell an underlying asset at a specified price within a specified time frame.

option premium: The price that an option buyer pays to the option seller for the rights conveyed by the option contract.