What is a Covered Call?

A covered call is an options strategy where an investor sells (or “writes”) a call option on a stock they own. This call option grants the buyer (the other party) the right, but not the obligation, to purchase the stock at a specified price (the strike price) on or before a certain date (the expiration date).

Why Use a Covered Call?

Investors might use a covered call strategy for several reasons:

• Generate Income: Selling a call option allows the investor to receive a premium payment from the buyer. This premium can provide a steady source of income, particularly appealing if the stock price is expected to remain flat or grow only slightly.
• Reduce Risk: While providing immediate income, selling a call option also caps the maximum profit at the strike price, which can limit gains if the stock price significantly increases. This trade-off can be a strategic way to lock in profits on a stock that has appreciated.
• Offset Portfolio Volatility: A covered call can reduce portfolio volatility because the premium received may offset some downside risk, making it an attractive strategy for smoothing out portfolio returns.

Example of a Covered Call

Consider an investor owning 100 shares of XYZ stock, currently trading at $100 per share. The investor sells a call option with a strike price of $110, expiring in 3 months, for a premium of $5 per share.

• If the stock price stays below $110 at expiration, the option expires worthless, allowing the investor to retain the premium.
• Should the stock price exceed $110 at expiration, the option buyer will likely exercise, buying the shares at $110 each. The investor receives $11,000 from the sale, plus the $500 premium, totaling $11,500.
• If the stock price rises but does not exceed the strike price, the option expires worthless, and the investor keeps the premium and the shares, which may continue to appreciate.

Risks of Covered Calls

While potentially profitable, covered calls carry risks:

• Stock Price Decline: Despite receiving a premium upfront, there’s a risk the stock price could drop significantly, leading to a net loss if the decrease in the stock’s value outweighs the premium.
• Capped Profit Potential: If the stock price skyrockets above the strike price, the investor misses out on gains beyond this threshold, as they are obligated to sell at the strike price.
• Early Exercise Risk: There’s a possibility the option could be exercised early, leading to a forced sale of the stock. However, the investor retains the premium and any accrued gains up to the strike price.

Conclusion

Covered calls can be a beneficial strategy for investors looking to generate income, reduce risk, or mitigate portfolio volatility. However, it’s crucial to understand the associated risks and to consider this strategy as part of a broader investment approach, particularly suitable for those anticipating moderate growth or sideways movement in their stock investments.