A covered call is an options trading strategy that involves holding a long position in an underlying asset, typically shares of stock, and selling (writing) a call option on that same asset to generate additional income. This strategy is employed by investors looking to earn premium income from the call options, while accepting the obligation to sell the underlying asset at the strike price if the buyer of the call option decides to exercise it.
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Mechanics of a Covered Call
Holding the Underlying Asset
The primary component of a covered call is the ownership of the underlying asset. For example, if an investor owns 100 shares of a particular stock, they can sell one call option contract (since one options contract typically represents 100 shares of the underlying stock).
Selling the Call Option
Upon selling a call option, the investor (option writer) receives a premium from the buyer of the option. This premium acts as immediate income but comes with an obligation. If the stock’s market price exceeds the strike price of the option at expiration, the option is likely to be exercised, and the investor must sell the shares at the predetermined strike price.
Considerations and Benefits
Income Generation
The primary benefit of a covered call is the generation of additional income through the premium received from selling the call option. This can serve as a steady income stream, particularly in neutral-to-bullish market conditions.
Limited Risk and Reinvestment Opportunities
Because the underlying asset is already owned, the risk is limited relative to an uncovered call (naked call). Additionally, the premium received can be reinvested for further gains.
Example of a Covered Call
Consider an investor owns 100 shares of XYZ Corp., each valued at $50. The investor sells a call option with a strike price of $55, expiring in one month, and receives a $2 per share premium. Here’s how the outcomes can vary:
- Stock Price < $55: The option expires worthless, and the investor keeps the $2 premium plus retains the shares.
- Stock Price = $55: The shares are called away at $55, and the investor still keeps the premium, locking in a total gain.
- Stock Price > $55: The shares are sold at $55, and the investor forfeits some potential upside but retains the premium plus the increase from $50 to $55 on the stock price.
Historical Context and Application
Historical Adoption
The concept of covered calls has been around since the early 20th century but gained significant popularity with the advent of modern options markets and trading platforms in the 1970s.
Applicability in Modern Finance
Today, covered calls are commonly used by institutional and retail investors alike. They are particularly suitable for those seeking to increase the yield on their holdings without taking on the high risks associated with naked options trades.
Related Terms
- Naked Call: Selling a call option without holding the underlying asset, posing unlimited risk if the underlying asset’s price rises significantly.
- Put Option: A contract giving the owner the right, but not the obligation, to sell the underlying asset at a specified strike price on or before a specified date.
- Strike Price: The set price at which the call option writer may be required to sell the underlying asset.
FAQs
What is the main advantage of a covered call?
Is there a risk of losing the underlying asset in a covered call?
Can you lose money on a covered call?
References
- Hull, J. C. (2018). Options, Futures, and Other Derivatives. Pearson.
- McMillan, L. G. (2004). Options as a Strategic Investment. New York Institute of Finance.
Summary
A covered call is a versatile and strategic approach for investors looking to harness their existing holdings to generate additional income through the sale of call options. By understanding the dynamics of this strategy and its associated risks, investors can manage their portfolios more effectively, balancing income generation with exposure to market movements.
This detailed entry on covered calls provides a thorough understanding of this options trading strategy, offering insights into its benefits, mechanics, historical context, and practical application.
