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Demystifying an Options Strategy: Covered Calls

Updated: Feb 2


The covered call is an options strategy where an investor writes, or sells, call options against shares of a stock that they already own. This strategy can generate income through the premium received from selling the call option, and it can also provide some downside protection for the underlying stock. Despite these advantages, covered calls do have some risk. For instance, there is a risk that the stock may increase significantly in value and you'll miss out on those potential gains because you've committed to sell at the strike price. In this article, we will delve deeper into the concept of writing covered calls, discussing its advantages and potential drawbacks, and providing illustrative examples.



How Covered Calls Work


Let's imagine you own 100 shares of a company named XYZ, which is currently trading at $50 per share. You believe that the price of XYZ will rise slightly or remain steady over the next month. To generate some income, you decide to write a covered call. You sell a one-month call option with a strike price of $55, and receive a premium of $2 per share ($200 total for the 100 shares). This premium is yours to keep, no matter what happens next.


There are two main scenarios that can occur:


XYZ stays below $55: If the stock price stays below the strike price of the call option, the option will expire worthless, and you keep the premium as well as your stock. This scenario would represent an ideal outcome because you've made a profit from the premium without losing your shares.


XYZ rises above $55: If the stock price increases above the strike price, the call option will be exercised by the buyer. You will have to sell your shares for $55 each, the strike price. In this case, you still keep the premium and you've also made a profit from selling your shares ($55 - $50 = $5 per share). However, if the stock price skyrockets to, say, $70, you've missed out on the potential profit you could have made if you hadn't written the covered call.


Examples of Covered Calls


To better understand covered calls, let's look at two examples:


Example 1: Profit Scenario: You own 100 shares of ABC Inc., which you bought for $20 per share. The stock is currently trading at $25. Expecting little to no increase in the share price over the next month, you decide to sell a call option with a strike price of $30 and an expiration date one month away. For this, you receive a premium of $1.5 per share, or $150 total. If at the end of the month, ABC is still trading at $25 (or anywhere below $30), the call option will expire worthless. In this scenario, you've made a profit of $150 from the premium, and you still own your 100 shares of ABC Inc.


Example 2: Loss Scenario: Continuing with the example above, let's imagine that ABC Inc. announces a breakthrough in their product line and the stock price jumps to $35. In this case, the call option you sold will be exercised. You'll have to sell your 100 shares for $30 each (despite them now being worth $35). In this scenario, your profit from selling the shares is $10 per share (selling at $30 vs. buying at $20), plus the premium of $1.5 per share, totaling $11.5 profit per share or $1,150 total. However, you missed out on an additional profit of $5 per share because the stock price rose to $35 and you had to sell at $30.


Advantages and Drawbacks of Covered Calls


Writing covered calls has several advantages:


  • Income Generation: One of the primary benefits of writing covered calls is the income generated from the premiums received. These premiums can help to offset potential losses if the underlying stock's price falls, or add to gains if the stock's price rises but remains below the strike price of the written call option.

  • Downside Protection: The premium received from selling the call option provides a small buffer against losses if the price of the underlying stock falls. However, it's important to note that this protection is limited to the amount of the premium received.

  • Profit if Stock is Flat or Falls Slightly: Even if the stock price stays flat or falls slightly, you can still profit from the premium received when you write a covered call.


However, there are also potential drawbacks to consider:


  • Limited Upside Profit: If the stock price rises significantly, you miss out on potential profits because you're obligated to sell the stock at the strike price of the call option. In other words, you've capped your potential gain on the stock in return for the premium received.

  • Potential for Losses: While the premium provides some downside protection, it does not prevent losses if the stock price falls significantly. If the price of the underlying stock falls below your purchase price minus the premium received, you will incur a loss.

  • Tax Considerations: Depending on the country and specific circumstances, the premium received from writing a covered call may be subject to taxes. It's always best to consult with a tax advisor when engaging in options strategies.


Writing covered calls can be an effective strategy for generating additional income from a stock that you own and believe will not increase significantly in price. However, it's important to carefully consider the potential risks and rewards before writing a covered call. Remember that while you can profit from the premium received, you also limit your potential upside on the stock and still face risk if the stock price falls. Like all investment strategies, it's important to fully understand how it works and to consider your own risk tolerance and investment objectives before proceeding. As always, consider consulting with a financial advisor before embarking on this, or any other, investment strategy.


 

Despite its potential risks and complexity, the covered call strategy is actually one of the most commonly used options strategies among individual investors. This is largely because it's a relatively conservative strategy that can be used to generate income, while still allowing the investor to hold on to their shares of a stock. Moreover, it's also one of the few options strategies that's permitted in retirement accounts like Individual Retirement Accounts (IRAs) in the United States, making it an accessible strategy for a wide range of investors.

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