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 additional income. This strategy allows the investor to earn premiums from the call options while maintaining ownership of the underlying asset, which can provide a potential hedge against minor price declines.

5 Must Know Facts For Your Next Test

1. In a covered call strategy, the investor sells call options while already owning the underlying asset, which means they are 'covered' against potential obligations if the option is exercised.
2. Selling covered calls can provide a source of income through collected premiums, which can enhance overall returns on investment.
3. If the stock price exceeds the strike price of the sold call options, the investor may be obligated to sell their shares at that strike price, potentially limiting upside gains.
4. Covered calls are typically used in a flat or slightly bullish market outlook, as they allow investors to profit from premium collection without expecting significant price appreciation.
5. The risk of this strategy includes missing out on large price increases of the underlying asset since selling the call option caps potential gains.

Review Questions

• How does selling call options in a covered call strategy affect an investor's risk exposure?
  • Selling call options in a covered call strategy reduces an investor's risk exposure by providing immediate income through premiums. This income acts as a buffer against minor declines in the asset's price. However, it also introduces a cap on potential gains if the underlying asset appreciates significantly beyond the strike price of the sold calls, which means that while some risk is mitigated, there is still a trade-off involved.
• Discuss the advantages and disadvantages of using a covered call strategy for income generation.
  • The advantages of using a covered call strategy include generating additional income through premiums collected from selling call options, enhancing overall returns on investments. Additionally, this approach allows investors to maintain ownership of their assets while providing some downside protection. On the downside, if the underlying asset's price rises sharply, investors may miss out on significant capital appreciation since their shares could be called away at the strike price. Moreover, this strategy may not provide adequate protection during major market downturns.
• Evaluate how market conditions influence the effectiveness of covered call strategies and provide examples of scenarios where it may be most beneficial.
  • Market conditions significantly influence the effectiveness of covered call strategies. In a stable or slightly bullish market, where prices are expected to remain flat or rise moderately, selling covered calls can maximize income without risking large losses. For example, if an investor holds shares of a stock that they believe will trade sideways over the next few months, implementing a covered call can provide regular premium income without sacrificing much upside potential. Conversely, in a volatile or strongly bullish market, this strategy may lead to missed opportunities for substantial gains if stock prices surge past the strike prices of sold calls.

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 specific time frame.

Premium: The price paid by the buyer of an option to the seller for the rights conveyed by the option, representing income for the option seller.

Hedging: A risk management strategy used to offset potential losses in investments by taking an opposite position in related assets.