Options Strategy – Covered Call

How It Works

1. Hold the Underlying Asset: The trader owns the underlying asset (e.g., stocks).
2. Sell Call Options: The trader sells call options on the owned asset, receiving a premium.
3. Market Movement: If the price of the underlying asset remains below the strike price, the options expire worthless, and the trader keeps the premium.
4. Exercising the Option: If the price rises above the strike price, the options may be exercised, requiring the trader to sell the asset at the strike price.

Example of a Covered Call Strategy

Let’s say you own 100 shares of Company XYZ, currently trading at $50 per share. You decide to sell a covered call with the following specifics:

• Underlying Asset: Company XYZ stock
• Strike Price: $55
• Premium: $2 per share
• Expiration Date: 1 month from now

You sell one call option contract, which represents 100 shares, so you receive:

100 shares×$2 (premium)=$200100 \text{ shares} \times \$2 \text{ (premium)} = \$200100 shares×$2 (premium)=$200

Scenarios

1. Stock Price Remains Below Strike Price
   If, at expiration, the stock price remains at $50 or falls:
   • The call option expires worthless.
   • Keep the Premium: You keep the $200 premium.
   • Retain the Shares: You still own the 100 shares of Company XYZ.
   • Net Gain: $200 (premium received).
2. Stock Price Rises Above Strike Price
   If, at expiration, the stock price rises to $60:
   • The call option is exercised.
   • Sell the Shares: You sell the 100 shares at the strike price of $55.
   • Proceeds from Sale: $55 \times 100 = $5500
   • Market Value of Shares: $60 \times 100 = $6000
   • Opportunity Cost: $6000 (market value) – $5500 (strike price) = $500
   • Total Gain: $500 (capital gain from $50 to $55) + $200 (premium) = $700

Benefits of Covered Call

• Income Generation: Provides additional income from the premiums received.
• Limited Downside Protection: The premium received provides some cushion against minor declines in the stock price.
• Simple Strategy: Easy to implement and manage for investors who already own the underlying asset.

Risks of Covered Call

• Limited Upside: Caps the potential profit if the underlying asset’s price rises significantly.
• Ownership Risk: The trader must own the underlying asset, which exposes them to the risk of a decline in the asset’s value.

The Covered Call strategy is an excellent choice for investors looking to generate extra income from their stock holdings with limited risk.