What is a “Covered Call” trade?

by RobertB
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What is a Covered Call?

By ROBERT BOND

Options contracts can be a great tool for the savvy investor. This brief article will cover using a Covered Call options strategy to generate income while owning the underlying asset (stock).

Buying a Call option on a stock gives the buyer the right, but not the obligation, to purchase a specific stock at a specific price at a specific time in the future. The difference with the Covered Call options we will discuss is that you actually sell the Call options instead of buying. In that case, you are selling the right to buy a specific stock, at a specific price, at a specific time in the future to someone else.

Buying a Call option is a bullish strategy, whereas a Covered Call Option is a neutral strategy. In a Covered Call strategy, the investor actually owns the underlying asset and then sells the Call option to another buyer. The investor only expects a minor increase or decrease in the underlying stock price for the written call option’s life. The Covered Call Options Strategy is deployed when an investor has a short-term neutral view on the stock price. For that reason, the trader holds the underlying asset long and simultaneously has a short position via the sold Call Option to generate income from the option premium.

 

Example:

  • Trader buyers 100 shares of RKT at $20 each on 12/30/20 for $2,000.00
  • The trader is bullish on RKT long term, but they have a neutral outlook in the short term. Meaning, they don’t care if there are minor increases or decreases in price.
  • The trader does not expect a big swing in price in the next 30 days. The trader would be willing to sell their shares at $23.00 at the end of January. 
  • The trader can sell Call Options with a $23 strike price with expiration on 1/29/21 (The last trading day of the month) for a premium of .55 cents per share. ($55 premium per contract. Each contract holds 100 shares as collateral.)

In the trade example above, one of two things will occur.

  1. At the end of normal trading hours on 1/29/21 (The expiration date of the sold Call Options contracts), the price of RKT closes at $22, for example, which is below the strike price on the Options contract of $23. If this occurs, the Call Option seller gets to keep their shares as well as the premium generated from the sale. In this case, the seller of the call options would keep their 100 shares that were purchased at $20 each and now worth $22 each, as well as the $55 from the Option sale. Their account’s total net value would be $2,255.00 less any broker fees associated with the round trip trade.
  2. At the end of normal trading hours on 1/29/21 (The expiration date of the sold Call Options contracts), the price of RKT closes at $24, for example, which is above the strike price on the Options contract of $23. If this occurs, the Call Option seller will have their shares “called away” at $23 each. In this case, the call options seller would sell their 100 shares that were purchased at $20 each and now worth $24 each (Called away at $23 each) minus any fees associated with the exchange. The Call Seller limits their upside potential by the associated strike price. Their account’s total net value after call expiration would be $2,355.00 ($23 per share x 100 shares) + ($55 call premium).  While this would still be a profitable trade, the trader could have made more money by holding onto the shares instead of selling the options.

Simplified Exposure Explanation – What is the maximum gain or maximum loss with this type of trade?

The maximum profit of a covered call is equivalent to the strike price (The price at which the call option is executed) of the short call option (Sold call options are referred to as “Short call” options), less the purchase price of the underlying stock (From our example, the purchase price was $20 each), plus the premium received (In our example, the premium received was $.55 cents per share or $55 per contract).

The maximum loss is equivalent to the purchase price of the underlying stock less the premium received.

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