What is a Covered Call?
A covered call is a popular trading strategy that involves selling (or writing) call options on an asset that the trader currently owns. This strategy is also known as a buy-write. It essentially allows the trader to generate additional income from an asset by selling call options against it. The covered call strategy is typically employed when the trader expects a modest increase or no change in the price of the underlying asset.
How Does a Covered Call Generate Profit?
When you sell a covered call, you receive a premium from the buyer of the option. This premium is your immediate profit. The objective is to ensure that the price of the asset does not exceed the strike price of the call option before the expiration date. If the asset’s price remains below the strike price, the option will expire worthless, and you keep the premium as profit.
For example, imagine you own 100 shares of a stock currently priced at $50 per share. You decide to sell a call option with a strike price of $55 and receive a premium of $2 per share. If the stock price stays below $55 until the option expires, you retain the premium of $200 (100 shares * $2) as profit.
What Happens if the Asset’s Price Exceeds the Strike Price?
If the price of the asset increases beyond the strike price of the call option, your profit potential becomes limited. In this case, you are obligated to sell the asset at the strike price, even though its market price is higher. The maximum profit you can achieve is the difference between the strike price and the price at which you initially bought the asset, plus the premium received from selling the call option.
Continuing with the previous example, if the stock price rises to $60, you will be required to sell your shares at $55, the strike price. Your profit will be the difference between the strike price ($55) and your purchase price ($50), which is $5 per share, plus the $2 premium per share. Therefore, your total profit is $700 (100 shares * $7).
How Can You Mitigate Potential Losses?
If the asset’s price increases significantly and you want to avoid selling your shares at the strike price, you can consider buying back the call option. By purchasing an option with the same strike price and expiration date, you effectively close out your position and limit your losses. However, this action will incur additional costs, which may reduce your overall profit.
For instance, if the stock price rises to $60 and the call option you sold has appreciated to $7, you can buy back the call option for $700 (100 shares * $7). Although this reduces your profit by the cost of buying back the option, it allows you to retain ownership of your shares and potentially benefit from further price increases.
What is an Uncovered Call?
An uncovered call, also known as a naked call, is when a trader sells a call option on an asset they do not own. This strategy is riskier compared to covered calls because it involves potentially unlimited losses. If the price of the asset rises significantly, the trader must purchase the asset at the current market price to fulfill the obligation to sell it at the lower strike price.
Uncovered calls require a high level of risk tolerance and significant margin requirements. They are generally not recommended for inexperienced traders due to the potential for substantial financial loss.
Conclusion
Covered calls can be a valuable strategy for generating additional income from assets you already own. By selling call options, you can earn premiums while still participating in the modest upside potential of the underlying asset. However, it is essential to understand the limitations and risks associated with covered calls, such as the capped profit potential and the possibility of having to sell your shares if the asset price exceeds the strike price.
For new traders, covered calls offer a relatively safer way to dip their toes into options trading. As with any trading strategy, it is crucial to thoroughly research and understand the mechanics before implementing covered calls in your portfolio. With careful planning and risk management, covered calls can be a powerful tool in your trading arsenal.
