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What is Covered Call Option?

The terminology covered call option means a financial transaction where the investor sells the call options and owns an equivalent amount of the underlying amount. To execute this, the investor who holds the long position in an asset then writes call options on the same asset to generate an income path. The investor's long position in the asset is the cover as it means the seller could deliver the shares if the buyer of that call option wishes to exercise.

Objective of the Covered Call Strategy

A covered call strategy is a famous option strategy. It is mostly known to be low-risk when compared to others. It can assist you in generating income from your portfolio. Many brokers accept the selling of covered calls even in accounts that are not authorized to trade other options. The reason the covered calls are seen as low-risk is that the loss you can witness is little. With some other options contracts, you could be exposed to infinite risks.

With this strategy, you are not only profiting from losing money but also placing a limit on how much you can earn from the increase in the stock's price. In exchange, you will also get income in the form of the premium paid by the option buyer.

Features of the Covered Call Strategy

There are a few possible outcomes in the case of execution in the covered call strategy, and they are mentioned below:

  1. Rise in the Stock Price

In this scenario, since an individual has effectively locked in the sale price of the stock by selling a call option, the individual will get to enjoy a guaranteed short-term profit. In addition to that, he or she will also get to pocket the premium that the buyer of the call option had paid. It is a positive situation.

  1. The Stock Price Falls

In this scenario, the individual will get limited protection from the downside because of the premium that he or she was able to pocket with the sale of the call option. The premium amount that is received can be utilized to reduce the impact of the loss that you had to witness as a result of the fall in the stock prices.

  1. The Stock Price Remains the Same

When the prices of the stock stay neutral without any changes - the profit would be the amount of premium that the investor was able to take away by selling the call option contract of that stock. This is the situation irrespective of whether the option is exercised by the buyer or not. Sometimes, the buyer would not want to exercise the option where you can get to enjoy the premium and also hold onto your shares.

Benefits of a Covered Call

Covered calls will give you mostly three benefits, and they are mentioned below:

  1. The Received Premium

For this reason - a lot of investors employ covered calls and have a program of selling covered calls on a regular basis. This is sometimes monthly, sometimes quarterly – with the goal of boosting their annual returns by several percentage points.

  1. It assists in investors targeting a selling price for the stock above the current price

Stock is bought for 39.30 per share, and a 40 Call is sold for 0.90 per share, for example. If the covered call is assigned - which means the stock must be sold, you would be paid the total of 40.90. This does not include the commissions. Even if the stock price only goes up to 40.50, the assignment will come out in a total payment of 40.90. If the investor is ready to sell the stock at this price - then the covered call can help him achieve his goal, even if the stock price never reaches that level.

  1. Another cause for certain investors to sell covered calls is to get a limited amount of downside protection

In the case above, the 0.90 per share premium earned lowers the break-even point of owning this stock, lowering risk. However, because the premium obtained from selling a covered call is only a small percentage of the stock price, the protection – if it can be called that – is quite limited.

What is Covered Call Option? - FAQs

Is a covered call profitable?

Covered calls, like any other trading method, may or may not be profitable. If the stock price climbs to the strike price of the covered call that was sold and no higher, the covered call pays out the most. As the option expires worthless, the investor gains from a minor rise in the stock and collects the full premium. Covered call writing, like any other strategy, has benefits and drawbacks. Covered calls, when used with the correct stock, can be a terrific method to lower your average cost or produce revenue.

Is there a covered Put?

Put options, unlike call options, give the contract holder the right to sell the underlying (rather than buy it) at a certain price. Selling short shares and subsequently selling a downward put would be the same position inputs. This, on the other hand, is unusual. Traders may instead use a married put, in which an investor with a long position in a stock acquires a put option on the same stock to protect against price depreciation.

Is it risky to sell the underlying stock before the covered call expires?

Yes, this can be a big risk because if you sell the underlying stock before the covered call expires, the call will be "naked" because you no longer own the stock. In theory, this is similar to a short sale and can result in endless losses.

What are the risks of a covered call?

The main disadvantages of a covered call strategy are the risk of losing money if the stock falls in value (in which case the investor would be better off selling the stock outright rather than using a covered call strategy), as well as the opportunity cost of having the stock "called" away and foregoing any significant future gains.

What is the major benefit of a covered call?

A covered call strategy has several advantages, including the ability to produce premium income and increase investment returns, as well as the ability to assist investors in choosing a selling price that is higher than the current market price.

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