The Truth About The Covered Call Strategy You Must Know

By Yash

Covered Call Strategy

Covered calls are a widely used and effective option strategy for generating income from stocks. However, because covered calls have a high risk of losing money, they aren’t appropriate for all investors. This article explains what a covered call is, how it works, and discusses its pros and cons. Covered calls can be a great way to generate income from stocks you would otherwise not want to sell at current prices. However, covered calls only make sense if you’re willing to own stock in the company for at least several months after selling the call. You see, selling a covered call means you must own the stock if the buyer of your call exercises their privilege to buy it from you at the strike price. If you don’t own the stock when that happens, your downside loss could be significant.

 

What is a Covered Call?

 

A covered call is an options strategy in which the investor owns (or “covers”) the underlying stock and sells call options on that stock. The investor must sell their stock at the strike price if the option is exercised. If the investor doesn’t already own the stock, they’ll need to buy it. Therefore, covered calls are only appropriate if you’re willing to own the underlying stock for at least several months after selling the call.

If you’re selling a covered call, you want the stock price to remain steady or increase slightly. This means that the option you sold is less likely to be exercised. If that option is exercised, you’ll have to sell your stock at the strike price, so you want the stock price to be higher to offset the lower premium from the call you sold.

 

How Does a Covered Call Work?

 

Let’s say you own 100 shares of Company XYZ, which is currently trading at $50 a share. You also own one call option contract on a three-month XYZ option with a strike price of $50 and a premium of $4. If you sell that call, you will receive a net credit of $400 ($400 is the amount you’ll receive after selling the call). If the call buyer exercises their right to buy your stock at $50, you will have to sell your 100 shares at $50, even if Company XYZ is trading at $60 a share.

That’s why you want to own extra shares beyond the 100 you own to cover the obligation to sell at $50. So in this example, you would want to own at least another 100 shares to cover that obligation. If Company XYZ is trading at $60 a share when the call is exercised, you will have to sell your 200 shares at $50 a share. In this scenario, you would have lost $100 ($4 from the premium you received when selling the call and $100 from the lower price you had to sell your shares).

 

Pros of Covered Calls

 

1. Guaranteed income from stocks

 

The main benefit of covered calls is that you can generate income from stocks you own. The ideal situation is to sell covered calls on stocks that you would not otherwise want to sell at current prices. Covered calls are a strategy for generating income from stocks you already own. You sell call options on those stocks, which obligates you to sell your stock at a specified price if the option is exercised. Therefore, you want the underlying stock price to remain steady or increase slightly so that the option is less likely to be exercised. And if the option is exercised, the net proceeds from the call sale are yours to keep as income.

 

2. Limited downside risk

 

Another benefit of covered calls is that they limit your downside risk in two ways. First, covered calls allow you to collect income from stocks you would otherwise not want to sell at current prices. Second, you’re likely to let the call expire worthless if the stock price remains steady or rises slightly. As mentioned above, the ideal situation is for the stock price to remain steady or increase slightly so that the call option is less likely to be exercised. If that call option is exercised, you will have to sell your stock at the strike price, so you want the stock price to be higher to offset the lower premium from the call option you sold.

 

Cons of Covered Calls

 

1. You have to own the stock

Covered calls are a strategy for generating income from stocks you already own. Therefore, you have to be willing to own the stock for at least several months after selling the call. If the call option is exercised, you will need to be prepared to sell your stock at the strike price. If you don’t already own the stock, you will have to buy it at the current price, which is likely higher than the strike price specified in the call option. That means you will have to sell your stock at a lower price than you paid for it and accept the lower profit or loss. So you have to be comfortable owning the stock for at least several months and willing to tolerate a lower profit or loss if you have to sell it at the current price.

 

2. Is a Covered Call Right for You?

 

Covered calls are a high-risk strategy that should only be used by investors willing to own stocks for at least several months after selling the call. That means you must be willing to accept the risk of holding the stock even if the price falls.

The risk of substantial losses is too high if you’re not willing to own the stock for at least several months after selling the call. That’s because if the stock price falls, the call option is more likely to be exercised. And if that happens, you will have to sell your stock at the strike price, even if the current price is lower than the strike price.

 

Conclusion

 

The main benefit of covered calls is that you can generate income from stocks you own. Suppose you are willing to own the stocks for several months after selling the call. In that case, covered calls are a high-risk strategy with the potential for significant losses as well as gains. Covered calls are a low-risk strategy for generating income from stocks that you would not otherwise want to sell at current prices. They are appropriate for investors willing to own the stocks for several months after selling the call. It is also important to remember that the financial markets are a great place to earn some profits. But they also come with their own inherent risks.

Experienced traders and investors know about this and maintain the precautions necessary to safeguard their trading capital. You should also find such techniques to have a long run in the financial markets. Covered calls are a great tool if you know how to use them in the correct manner. Do your research and take the help of experts involved in the financial markets before you decide to start investing and trading in the financial markets with this strategy. We wish you the best of luck and gains in your market sojourn.