How to Trade a Covered Call
Covered call options are a great way to generate steady income from your financial assets. With a covered call you sell (write) a call option against an underlying asset that you own. Covered calls allow the trader to enjoy both capital appreciation in the underlying asset as well as income from the calls that they sell. The trader can also enjoy the other benefits of share ownership such as voting rights and dividends. Here you will learn how you can create your own covered call options trades:
How to Write a Covered Call Option
To write a covered call you must either already own the underlying asset or purchase it at the time that you write the call. When you write a covered call you will receive what is called the premium. This is what the buyer pays you for the option to purchase your underlying shares at a given price.
If the call reaches the strike price by the expiration date then the buyer can choose to exercise the call option. In this case you will need to sell them the shares at the expiration price. If the strike price is not reached then you can keep both the premium and the underlying shares.
Example of a Covered Call Option Trade
In this example the traders buy 1000 shares in Company A which in September is currently trading at $25 a share. The trader decides to write an out of money OCT 28 call option for $1. The share price costs the trader 1000 x $25 = $25,000. The call the trader writes earns a premium of $1 x 1000 = $1000. The total cost of the trade is $25,000 – $1,000 = $24,000.
If by expiration date the share price has hit $27 a share. The trader can keep the $1,000 premium as well as enjoying $2,000 in the appreciation of the underlying share price.
If at expiration the share price breaks through the striker price and hits $28 a share the trader will be obligated to sell the shares at this price. This means that the trader will receive $28,000 or a $3,000 profit. The trader also gets to keep the profit from the trade. It is important to note that the upside of a covered call is limited to the strike price x the number of share + the premium.
Risks of Covered Call Trades
With a covered call option trade the potential loss is similar to that of owning the stock by itself. The share price of the underlying asset can potentially go all of the way to zero. However the call option writer takes less risk than someone who only buys the shares. The reason for this is that they still get to collect the premium even if the company was to go bankrupt.
Covered calls are perfect if you are looking to earn income from your share portfolio while still enjoying the benefits of capital appreciation. Writing covered calls can also lower the risk of purchasing stocks because of the premium that you receive. This is a good strategy for both active traders and investors alike.