Covered call

Definition

A covered call is an options trading strategy where an investor holds a long position in an asset and sells call options on that same asset to generate income. This strategy allows the investor to earn premium income from the options while still holding the underlying asset, providing potential benefits in a sideways or slightly bullish market. The risk in this strategy is that if the asset's price rises significantly, the investor may miss out on potential profits.

5 Must Know Facts For Your Next Test

1. In a covered call strategy, the investor typically sells call options with a strike price above the current market price of the underlying asset, limiting their potential upside if the asset's price increases significantly.
2. This strategy can provide downside protection as the premium received from selling the call options can offset some losses if the asset's price declines.
3. Covered calls are often employed by investors looking for income generation in addition to capital appreciation from their underlying investments.
4. The effectiveness of a covered call strategy can be influenced by market conditions, including volatility and time until expiration of the options sold.
5. If the stock price exceeds the strike price at expiration, the investor may have to sell their shares at that price, potentially missing out on larger gains if they had not implemented the covered call.

Review Questions

• How does a covered call strategy help manage risk while generating income?
  • A covered call strategy helps manage risk by allowing investors to collect premium income from selling call options, which can offset some losses if the underlying asset's price falls. By holding a long position in the asset while selling calls, investors can earn income even if the stock does not appreciate significantly. This approach is particularly useful in a sideways market where substantial upward movement is not expected.
• Discuss the advantages and disadvantages of using a covered call strategy compared to simply holding a stock.
  • The primary advantage of using a covered call strategy is the generation of additional income through premiums from sold options, which can enhance overall returns. However, one disadvantage is that it limits potential profits if the stock price rises significantly above the strike price. In contrast, simply holding a stock allows for full participation in any upside gains, but does not provide any additional income. Investors need to weigh their risk tolerance and market outlook when deciding between these approaches.
• Evaluate how market volatility affects the implementation of covered calls and overall investment performance.
  • Market volatility plays a crucial role in the effectiveness of covered calls. High volatility can lead to higher option premiums, making it more profitable to sell calls; however, it also increases the likelihood that stock prices will exceed strike prices, leading to potential missed profits. Conversely, low volatility results in lower premiums but may mean less risk of having to sell shares prematurely. Investors must assess current market conditions and their own strategies to maximize performance while using covered calls.

Related terms

Call Option: A financial contract that gives the buyer the right, but not the obligation, to purchase an underlying asset at a specified price within a specific time period.

Premium: The price paid by the buyer of an option to the seller for the rights conveyed by the option, which represents the seller's income in a covered call strategy.

Long Position: An investment strategy where an investor buys and holds an asset, expecting its price to rise over time.