Covered Call Strategy
November 16, 2023
A covered call strategy is one of the simplest and most conservative strategies a person can use when trading options. This strategy involves buying a stock and then selling call options against that stock to generate income. While this strategy has some risks, it can also be used to limit downside potential and provide stability to a portfolio. In this article, we will discuss the basics of the covered call strategy and how you can use it in your trading!
What is Covered Call Strategy?
When an investor purchases or sells call options against shares they already own or stock they have bought specifically to engage in such a transaction, they are engaging in a covered call. When you sell a call option, you grant the buyer the right to acquire the underlying shares at a particular price and time. This gives the buyer of the call option more control over the investment.
Because you already hold the stock that will be sold to the buyer of the call option if they decide to exercise their option, this approach is considered to be "covered." If the stock price rises above the strike price, the buyer may choose to exercise their option, at which point you would sell them the stock at the agreed-upon price.
If the stock price drops, they may choose not to exercise their option, in which case you get to keep both the stock and the premium that you were paid for selling the call option.
Either way, selling covered calls can help generate income from your existing investments.
Two Steps of Covered Call Strategy
Covered call is a popular technique among investors who seek to generate income from their portfolios. The strategy involves the purchase of shares of stock, followed by the sale of call options on those same shares. The covered call technique can be used regardless of the investor's outlook on the market; however, it is most successful when employed on stocks with relatively stable prices. By selling call options, investors can profit from price movements in the underlying stock while also limiting their downside risk (more to this later).
There are two key elements to a covered call trade: the underlying stock and the strike price. The underlying stock is the security on which the option is based; in this case, it is the stock that has been purchased by the investor.
The strike price is the price at which the buyer of the option has the right to purchase shares of the underlying stock. When selling a covered call, it is important to choose a strike price below the stock's current market price. This ensures that there is room for the stock price to rise before the option is exercised, allowing investors to capture profits.
How Does a Covered Call Strategy Work?
In options trading, a covered call is a trading strategy in which the trader maintains a long position in an underlying asset while simultaneously writing or selling call options simultaneously. When referring to covered call options, the term "covered" refers to the fact that the person who writes the option is also the person who holds the long position in the underlying asset. The covered call strategy is one way to produce income from an asset that is not often anticipated to see a significant price change, either positively or negatively.
The covered call works by the trader selling call options at a strike price above the current asset price. If the price of the asset remains unchanged or declines, then the option will expire worthlessly, and the trader will keep both their long position in the asset and the premium received from selling the option.
If the asset price increases above the strike price, then the option will be exercised, and the trader will sell their long position at the strike price. The amount of profit generated from a covered call trade is limited to the premium received from selling the option, but this trade can still be profitable if done correctly
Covered calls are considered to have a low level of risk because they do not require a large up-front investment like other options strategies.
Is it profitable?
Covered call writing can be profitable even when there is only a small movement in underlying security prices. However, it is important to remember that covered calls have some risks. If there is a large move-up in the price of the underlying security, then it is possible that some or all of your profits may be taken away.
Stock Ownership vs. Covered Calls
When you purchase a stock, you are buying shares and selling the company's own price and agreeing to accept the risk that the store might lose some or all of its value in the future.
The stock price is influenced by many factors, including the company's overall performance, global economic conditions, and supply and demand. If you own shares of stock, you will experience gains or losses as the stock price fluctuates.
However, another way to profit from the current stock price is covered call selling. When you sell a covered call, you are selling the right to buy a specific number of stock prices of the underlying stock covered call position at a specified price. The buyer of the covered call has the right to purchase the stock from you at that price at any time before the expiration date of the contract.
If the stock price goes up, they may exercise their option and buy it from you at a lower price. You will still profit from your investment, even though you didn't benefit from the full increase in value.
If you decide to sell covered calls, you can receive payments for agreeing to sell their shares at a certain price, even if they never actually have to sell them. This can help offset some of the risks associated with owning stocks.
Advantages of Covered Call
Covered calls could potentially provide investors with five benefits:
Income Generation
Income generation is one benefit of covered call selling. When an investor writes a covered call, they are selling the right, but not the obligation, to buy shares of stock at a set price. The covered call buyer pays the investor a premium for this right. If the price of the underlying stock does not increase above the strike price before expiration, the covered call seller keeps the premium as income.
If the stock price does increase, the covered call seller may still receive some income, as they will sell their shares at the strike price and receive the premium in addition to any profits from the increase in stock price. Therefore, covered call selling can be a way to generate income from a long stock position while still potentially benefiting from increases in stock price.
Asset Protection
Asset protection is a key concern for many investors. Covered calls can help to mitigate some of the risks associated with owning assets that involve selling stocks. When you sell a covered call, you essentially sell an option on a stock you own.
If the price of the underlying asset declines, the premium from selling the covered call can offset some of your losses.
Additionally, if you own shares of stock that have increased in value, selling covered calls can help to lock in those gains. If the price of the underlying asset declines after you sell the covered call, you will still have the option to sell your shares at the strike price, which is typically above the current market price. This allows you to protect your profits in case of a market downturn.
While covered calls do involve selling away some potential upside, they can be a helpful tool for managing risk and protecting your assets.
Limited Downside Risk
We've already established that one of the key risks of owning stocks is that their value could decline. Covered calls can help to mitigate this risk by giving you a floor for the price of your shares.
When you sell a covered call, you agree to sell your shares at the strike price if the buyer chooses to exercise their option. This means that even if the stock price declines, you will still receive the strike price for your shares
While you give up the potential to profit from further increases in the stock price by selling a covered call, you also limit your downside risk. This can be helpful if you are worried about a potential market downturn or want to take some profits off the table but still hold on to your shares.
Potential for Increased Returns
In addition to the income you receive from selling the covered call, you also benefit from any increases in the price of the underlying asset
If the stock price goes up, you will profit from the increase just like any other shareholder. And, if the stock price goes up above the strike price, you will also benefit from the premium you received when you sold the covered call.
Therefore, covered calls can potentially increase your returns on investment. This is one reason why covered call selling is often used to generate income from a long stock position.
Flexibility
Covered call selling can provide you with some flexibility when it comes to your investment strategy
If you own shares of stock that you think will increase in value but are not sure when the best time to sell them is, selling a covered call can give you the ability to benefit from any future increases in the stock price while still having the option to sell your shares at the strike price
This can be helpful if you want to take some profits off the table but still hold on to your shares in case the stock price continues to increase. Additionally, if you are worried about a potential market downturn, selling a covered call can help to protect your profits while still allowing you to sell your shares if the price declines.
Takeaway
Implementing a covered call strategy is without its challenges. For covered calls to be effective, you need to have a good understanding of the underlying asset, the options market, and how to manage risk
Additionally, it is important to remember that selling covered calls will limit your upside potential if the stock price increases. However, if you are looking for a way to generate income from your long stock positions or protect your profits in a market downturn, selling covered calls can be a helpful tool! Lyons Wealth Management can help you realize the potential of your investments through our innovative and effective approach. Schedule a consultation to learn more!