A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying security. This strategy can be used to generate income on a security that is expected to have low price volatility, or to protect a long position in a security by selling call options on it.
Here’s how a covered call works:
- An investor buys a stock (also known as the “underlying security”) and holds it in their portfolio.
- The investor sells a call option on that stock to another investor. The option gives the buyer the right, but not the obligation, to purchase the underlying security at a predetermined price (also known as the “strike price”) on or before a specified date (also known as the “expiration date”).
- The investor receives a premium from the sale of the call option, which is the price the buyer pays for the option. This premium is the income the investor receives for selling the call option.
If the stock price remains below the strike price by the expiration date, the call option will expire worthless and the investor will keep the premium as profit. If the stock price rises above the strike price, the call option will be exercised and the investor will sell the stock at the strike price, potentially realizing a profit or loss on the sale depending on the stock’s price at the time of the sale.
Covered calls can be a useful strategy for investors who want to generate income on their portfolio while still holding onto their underlying securities. It’s important to note, however, that selling call options also limits the potential upside of the underlying security, as the investor is committed to selling the stock at the strike price if the option is exercised. As such, covered calls are best suited for investors who are comfortable with potentially missing out on larger price gains in exchange for the income generated from selling the call options.
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