A covered call is an over-the-counter and relatively simple options strategy used by investors to earn extra money on stocks in their own company. A covered call is an act of purchasing stock shares of a company and selling a call option on the shares. In a covered call strategy, an investor writes a call option on the stocks he or she already owns, and he or she receives a premium for committing to sell the stocks at the option’s strike price if the option holder exercises the option. The rationale is that the investor owns the stock (or “covers” the call) when writing the call option.
This puts the investor in a situation where regardless of whether the stock goes up or down, the investor gets to keep the premium received by selling the option and thus earns. Covered calls are that well-liked because they are simple and earn extra profits in flat or mildly bearish markets. For instance, if the individual has a stock that is trading at $50 and one sells a call option for $55, then one can retain the premium one makes on selling the call, which could be some dollars or a few cents per share.
This is extremely fascinating in sideways or weakly bullish scenarios when the stock price will not budge much. The big benefit of a covered call is that it is profitable without the stock needing to move very far. The only drawback is that if the stock price does move up and above the strike price, then the investor must sell the stock at that price, and therefore any profit is capped. In this, the investor gets to retain the premium but loses out on the future appreciation of the stock over the strike price. This strategy thus suits stocks that will undergo little growth or investors who will be selling stock at a set rate.
The most important is to choose an optimal strike price that is a compromise between wishing to earn premium income and the potential of the stock to the upside. Too high a strike price will pay too little premium to justify the trade; too low a strike price will make the stock vulnerable to being called away, giving up potential upside. Covered calls are most attractive to long-term investors who want to receive returns on stocks they are sure of holding but do not anticipate short-term value increases. It allows them to earn a consistent income from the premiums without having to sell their holdings.
It is a good way of topping up some downside risk as well since the premium earned for selling the call option acts as a cushion to minor declines. However, even though it‘s a conservative strategy, covered calls are not a good strategy for downside protection if the stock price drops significantly. If the stock price drops significantly, then the investor will have lost money but in the process have made the losses by getting premiums. The date of expiration is one of the most important points in a covered call strategy.
Short options are cheap but come with income prospects more frequently, and long options are expensive but bind the investor for a longer period. Traders need to choose the expiration date based on expectations regarding the stock’s as much as on target return for income. The strike price is the second essential ingredient in calculating the risk-reward setup of the trade. Traders need to remain highly sensitive regarding the equilibrium between the premium income they receive and the stock possibility of getting called away.
The most lucrative covered call scenario is when the stock neither moves nor increases slightly and the investor gets to keep the stock and premium. However, in case the price of the stock increases with an enormous jump, the investor gets very little profit and the covered calls are optimal where they are insuring small price movement.
This makes them very appropriate in range-bound stocks or scenarios where the investor expects the stock to have little price movement. Investors employing the covered call strategy should also consider tax implications in this strategy. Premium received is taxed by taking into account the investor’s holding period and tax status for whom the stock is being purchased. Second, in the event the stock gets called away, it will be liable to capital gains tax, depending on how long the investor has owned the stock.
So, a bit of prudent planning and guidance in the form of a tax advisor here is warranted. The second thing to remember here is to use covered calls on a dividend stock portfolio. Because the call premium can be invested in any dividend payment made, overall proceeds obtained by way of investment might be beneficial to shareholders in an attempt to earn a profit on the stock. The compromise with such a proceeding is that such an investment on the investor will displace the investor from the value of share appreciation should the price rise above the strike point.
It should also be pointed out that covered calls may not be attractive for all stocks or investors. Best options income strategies are covered calls, cash-secured puts, and iron condors, which are among the most widely used strategies enabling investors to earn consistent income while controlling risk in any market environment. Covered calls entailed owning a stock and selling a short call option against the stock so that investors receive premiums without giving up their stocks but at the cost of limiting future gains if the stock price is higher than the call option’s strike price. Very volatile stocks may not be suitable for covered calls because the premium received may be canceled out by the potential for wild price action.
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