What’s a Covered Call?
A covered call is a strategy used by traders and investors to generate income from stocks they own or will buy. To trade a covered call, you need to own the stock and be able to write a call option against those shares. These can be shares that you already own, or shares that you purchase as part of the covered call strategy. Investors may see great long-term value or potential in a stock but in the short term may seek to profit or earn premiums by selling call options. A covered call strategy can be traded over any time frame that you want. The calls you sell can expire from a few days in the future to months or years in the future.
A Call Option gives the buyer the right but not the obligation to purchase the stock at a specified price (strike price) within a given time period, while the seller of the call (“writer”) is obligated to sell his/her shares at strike price if the buyer decides to exercise the option. The buyer pays a premium to seller for that right.
Call options are purchased with the expectation of a price increase in the underlying asset while Call sellers (writers) are making the opposite bet, for a decrease in the price. If price increases, the hope is that it’s less than the premium received for selling the call.
Covered Call Scenarios
There are a few likely scenarios for a Covered call options strategy……
Assume Investor sells a call option for SCT shares currently trading at $9
Strike Price is $15, Call option Premium is $0.70 ($70.00 per contract of $100 shares)
• If SCT shares trade below the $15 strike price, the option expires worthless as the buyer will likely not exercise the right to buy as they could get it cheaper in the market. The seller would keep the $0.70 credit they received when they sold the call options, and they would keep the shares they own.
• If SCT shares increased above the $15 strike price, the option would be exercised. The trader, prior to expiry has a decision to make. They could buy the call option back at a loss, or they could allow the call option to be exercised and have to hand over the shares they own.
Covered calls are considered a lower risk trading strategy, however there are certain market conditions that make the strategy a popular one. The best market conditions to trade covered calls are sideways markets or markets that are slowly moving up.
Markets that are moving quickly up, or moving quickly down can pose issues for a covered call trader. If the stock is moving up too quickly then the call option that was sold will be in the money and the trader will have to give up their shares or buy back the call at a loss. If the trader gives up their shares and the stock continues to increase in value then they will be forced to buy back the stock at a higher price in the future.
If the stock moves down quickly then the credit that is taken in from the option might not be enough to cover the loss in the value of the stock over time.
No trading strategy is risk free and you should understand all of the potential risks of your strategy before you trade it.