Covered call

Definition

A covered call is an options trading strategy where an investor holds a long position in an asset and sells call options on that same asset to generate income. This strategy is commonly used to enhance returns on stocks the investor already owns while providing some downside protection. By selling the call options, the investor collects a premium, which can offset losses if the asset's price declines.

5 Must Know Facts For Your Next Test

1. In a covered call strategy, the call options sold typically have a strike price higher than the current market price of the underlying asset.
2. The maximum profit from a covered call occurs when the underlying asset's price rises to the strike price of the sold call option, resulting in capital gains plus the premium received.
3. This strategy can limit upside potential since if the asset price exceeds the strike price, the investor may be forced to sell their shares at that strike price.
4. Covered calls are often used by investors who expect minimal price movement in their assets, allowing them to earn income through premiums without significant risk of loss.
5. While this strategy can provide additional income, it does not protect against significant declines in the underlying asset's price, as losses could exceed the premiums collected.

Review Questions

• How does a covered call strategy provide income while still holding onto an underlying asset?
  • A covered call strategy allows an investor to generate income by selling call options against shares they already own. When they sell these call options, they receive a premium which adds to their overall returns. This approach enables investors to profit from their assets while still retaining ownership and benefits from any potential appreciation up to the strike price of the option.
• What risks and limitations should an investor be aware of when employing a covered call strategy?
  • Investors using a covered call strategy should be aware that it limits their upside potential because if the asset's price exceeds the strike price, they must sell their shares at that predetermined price. Additionally, while they earn income through premiums, this strategy does not shield them from significant losses if the underlying asset's price declines sharply. As a result, investors may still face substantial risks if market conditions change dramatically.
• Evaluate how market conditions influence the effectiveness of a covered call strategy for different types of investors.
  • The effectiveness of a covered call strategy greatly depends on market conditions and investor goals. In stable or mildly bullish markets, this strategy can provide consistent income while allowing for some capital appreciation. However, in highly volatile or bearish markets, investors may find that relying solely on premiums does not adequately compensate for potential losses. Moreover, more aggressive investors may seek higher returns elsewhere instead of capping their profits through this conservative approach.

Related terms

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

long position: An investment strategy where an investor buys and holds an asset with the expectation that it will increase in value over time.

option premium:

The price paid by the buyer of an option to the seller, representing the seller's potential obligation under the terms of the option.