When it comes to investment tools and strategies, few are as valuable and versatile as covered calls. But what is a covered call?
Here, we take a closer look at covered calls, including the pros, cons and potential applications of the lower-risk options strategy.
What is a covered call?
A covered call strategy is rooted in the idea of optimizing the returns on your investment holdings by combining stock ownership with the strategic sale of call options against those already-owned shares.
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Let's break this down for a clearer perspective:
Owning the stock (the "covered" part): Consider a scenario where you hold a substantial position in a stable and promising company, referred to here as "ABC Corporation." You harbor a positive outlook on the company's prospects, yet you'd like to augment the stock returns.
Selling call options (the "call" component): This is the core of covered calls. By selling a call option on your ABC Corporation shares, you are effectively granting another investor the right (though not the obligation) to purchase your shares at a predetermined price, known as the "strike price," within a specified time frame, known as the "expiration date."
The motivation behind the call buyer purchasing the options lies in their belief that ABC Corporation's stock is poised for growth, and they are hoping to pick up the shares at a discount.
Meanwhile, as the seller, you collect the premium which you can keep as income. By doing so, however, you are committing to part with your shares at the strike price – and forfeit the right to participate in any additional upside in stock – should the shares be trading above that level at expiration.
How do covered calls work?
The phrase "covered call" derives from the fact that you possess the shares you are offering in the options contract.
In essence, your existing stock holdings "cover" the contractual obligations assumed when selling the call options.
This ensures that you are not exposed to undue risk in the event of substantial stock price increases.
What are the pros of covered calls?
Now that we've laid the foundation of what a covered call is, let's delve into pros of this options strategy.
Income augmentation. The covered call strategy facilitates the generation of immediate income through the premium received from selling the call options. The option seller keeps this premium regardless of whether the option is ultimately exercised.
Enhanced portfolio returns. Should the stock price be below the strike price at the option's expiration, the calls will not be exercised. Investors can then retain both the premium collected and the underlying shares, further enhancing the investment's overall return potential.
Risk mitigation. Incorporating covered calls within a portfolio allows investors to mitigate risk. The premium received from selling the call options serves as a cushion against potential stock price declines, thereby minimizing downside exposure.
Consistent income stream. For investors seeking a dependable income stream, the covered call strategy offers a structured approach. Regularly selling call options on existing holdings can create a consistent source of income, transforming investments into income-generating assets.
Frequently asked questions about covered calls
Is the covered call strategy suitable for conservative investors? Absolutely. Covered calls provide an avenue for conservative investors to generate additional income from existing investments while maintaining a degree of risk management.
What happens if the stock price exceeds the strike price? This is the biggest risk associated with the covered call strategy. Should the stock price be above the strike price at the option's expiration, investors may be required to sell their shares at the predetermined strike price. This means potentially missing out on substantial gains, though the premium collected remains intact.
Can I repurchase the call options I sold? Indeed, investors have the option to buy back the call options they initially sold. This action, known as "buying to close," allows investors to retain ownership of their shares.
What if I lack sufficient shares to fulfill my obligations? Many brokerages won't allow "naked" selling of calls - that is selling call options without owning at least 100 shares per options contract. Selling naked call options often requires a significant amount of margin, as investors may need to acquire shares in the open market to fulfill their commitments.
The bottom line on covered calls
Covered calls are a potent tool for investors seeking to optimize portfolio returns while mitigating risks.
Armed with a comprehensive understanding of this approach, investors are poised to capitalize on the income-generating potential and the downside protection it offers.
With knowledge as their guide, investors can strategically incorporate covered calls into their investment strategy, paving the way for more robust and secure financial growth.
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