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Options Strategy – Covered Call


A Covered Call strategy involves holding a long position in an underlying asset while simultaneously selling (writing) call options on that same asset. This strategy is used to generate additional income from the premiums received by selling the call options, and it can provide some downside protection. However, it also limits the upside potential of the underlying asset.

  • Market Direction: Upward
  • Difficulty: Easy

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.

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