When it comes to investing and trading in derivatives such as options, one must exercise an exceptional amount of caution. This is primarily because options trading is far riskier than just investing in regular equity. That’s probably why most seasoned investors employ specialized options trading strategies to minimize their risk and limit their losses. One such options strategy that veteran traders and investors use on a day to day basis is the covered call. If you’re wondering what this is, here’s everything that you should know about the covered call option strategy.
What is a covered call?
The covered call strategy essentially involves an investor selling a call option contract of the stock that he currently owns. By selling a call option, the investor essentially locks in the price of the asset, thereby enabling him to enjoy a short-term profit. Apart from this, the investor also gets a slight protection from any future declines in stock prices.
When should you use the covered call option strategy?
The covered call is ideal for neutral and moderately bullish situations, where the future upside potential of the stock that you own is limited. This strategy is ideal when the outlook for the stock that you own is not very bright and when booking short-term profits would be a better idea than to keep holding the stock.
How does the covered call strategy work?
For utilizing a covered call option strategy, you’re required to first own the stock of a company. So, let’s assume that you already hold the stock of a company i.e. going long. Your view when you bought the stock was bullish, but as time passed, you’re now unsure of the future upside potential for the stock and so you don’t expect the price to rise much.
Under such a situation, what do you do? You can book a short-term profit and protect yourself from minor downsides in the price of the stock by using the call option contract of the stock. And so, you sell a call option contract of the stock at a strike price that’s higher than the purchase price of the stock. The buyer of the call option would in turn give you a premium, which you’re obligated to keep whether the option is exercised or not.
Now, here’s where things get exciting. After you execute a covered call strategy, one of three scenarios is likely to happen. Let’s take a look at them one after the other.
Scenario 1: The price of the stock rises
In such a situation, since you’ve effectively locked in the sale price of the stock by selling a call option, you get to enjoy a guaranteed short-term profit. In addition to this, you also get to pocket the premium that the buyer of the call option paid you. Therefore, it is a win-win situation.
Scenario 2: The price of the stock falls
In this scenario, you get limited protection from the downside thanks to the premium that you were able to pocket by selling the call option. This premium amount that you received can be used to reduce the impact of the loss that you had to suffer as a result of the fall in the stock price.
Scenario 3: The price of the stock remains the same
When the price of the stock remains neutral without any changes whatsoever, your profit would actually be the amount of premium that you were able to pocket by selling the call option contract of the stock. This is the case irrespective of whether the option is exercised by the buyer or not. Sometimes, the buyer might not want to exercise the option, in which case you get to enjoy the premium as well as hold onto your shares.
One of the advantages of the covered call is the fact that you don’t have to time the purchase of your stock and the sale of the call option contract. You can sell the call option anytime after you’ve purchased the stock. That said, it is a good idea to always exercise a bit of caution when dealing with options and options strategies due to the amount of risk involved.