What are covered calls?

We know that a ‘Call’ refers to the right (with no obligation) to buy a stock at a specified price within a certain time frame, and that a single option contract is for 100 shares of the underlying stock.  It’s an agreement between an option seller and an option buyer where the seller receives a premium from the buyer who is paying for that right, and the seller keeps that premium regardless of how the markets move.

A ‘Covered Call’ is a when you are selling the option on stock that you already own. For most options traders, this is the only type of Call you can sell.

Profitability

The profit potential lies in the income generated in collecting the Option premium, plus potentially more in the sale of the stock. But no matter which way the stock price moves, that premium is yours to keep.

If the Option finishes ITM (stock price above the strike price), as a seller you would receive the option premium and sell the stocks at the strike price. So your overall profit would be the option premium, plus the difference between the strike price and the price you purchased the stock for.

If the Option finishes OTM (stock price below the strike price), you would still receive the option premium, and you would retain your stock.

Unfortunately for the buyer, their option would expire worthless in this situation.

Risk

When you sell an option to open the position, it’s considered a short option. If the stock doesn’t go the direction you want it to, you can be on the hook for potentially big losses. Selling it covered essentially protects you from losses on the option if the stock skyrockets because you’re already holding the stock to sell. If you didn’t own the stock, you would have to buy it on the open market to cover your position, potentially at a significantly higher price than you have committed to sell it at (your strike price).

The greatest risk of this strategy actually isn’t on the option itself, but on the stock. When you’re holding 100 shares of a stock, and the price falls dramatically, the value of your position decreases with it. However, if you’re able to hold on to the stock until the price recovers, you never actually take this loss. And as a reminder, you keep the option premium no matter what.

As you can see, a Covered Call is actually a very low risk options strategy.

Overall, using covered calls is a simplistic way to generate an options premium income with generally low risk. It’s also a very beginner friendly strategy, great for new investors as they start to navigate through options trading. But it’s also used by experienced investors, and many times along with other strategies.

Is there an options trading strategy you use often or would like explained? Leave a comment or send a message!