What are Covered Calls?

Covered calls are a financial trading strategy where an investor who owns a stock sells call options on the same stock. This approach is often used to generate income through option premiums.

Benefits of Covered Calls

  1. Income Generation: Investors earn from the option premiums.
  2. Risk Management: Can help offset minor price declines in the owned stock.
  3. Controlled Strategy: Investors maintain ownership of the underlying stock, giving a degree of control over the assets.

Downsides and Risks of Covered Calls

  1. Capped Gains: If the stock price rises significantly, the investor only benefits up to the strike price.
  2. Potential Stock Loss: If the stock’s value exceeds the strike price, the investor might have to sell the stock at a lower price than current market value.

Example of Covered Calls

Imagine owning 100 shares of XYZ Corp at $50 each. You sell a call option with a strike price of $55, expiring in one month, for a $2 premium per share. Note that one contract consists of 100 shares. You cannot have a contract in less than 100 share increments, but you can buy multiple contracts at 100 share increments.

Explaining the Profit and Loss

  • Profit Scenario: If XYZ stays below $55, you keep the premium and the stock. In this example, at the $2 premium per share, this option would net $200 ($2 x 100 shares)
  • Loss Scenario: If XYZ exceeds $55, you would sell your shares at $55, missing out on any additional gains above $55 (the strike price you selected).

When Should Traders Sell Covered Calls?

Sell covered calls when:

  1. You anticipate moderate growth or stagnation in the stock’s price.
  2. You desire additional income from your stock holdings.
  3. You’re willing to sell the stock at the strike price.

Questions Traders Should Ask Before Using this Strategy

  1. What is my target price for the stock?
  2. How will I manage if the stock price exceeds my expectations?
  3. Am I comfortable with potentially selling my stock at the strike price?