Covered call writing is a popular options strategy that enables an investor to generate additional income from their stock holdings.
How Covered Calls Work
A covered call strategy involves:
Owning shares of a stock
Selling out-of-the-money call options the stock.
By selling call options, the investor receives an upfront premium. In exchange, they agree to sell their shares at a predetermined price (the strike price) if the stock rises above that level by the option's expiration date. In essence, the investor is selling future upside for an upfront fee.
This can be a very effective strategy after a sustained stock price increase where the investor already has a profit on the stock and believes the stock will trade sideways for the short to medium term (typically 1-6 months).
Benefits of Covered Calls:
Generate income from option premiums
Provide limited downside protection
Potentially enhance overall returns
Risks
Covered calls are a more complex options trading strategy than purchasing put and call options to place an outright bet on market directionality. As such, not all brokerages will be able to facilitate covered call strategies due to the complexity of the risk management and margining.
Options are usually a much less liquid instrument than the underlying stock, and so it can be difficult to close out a covered call position prior to the option expiration date. This reduces the liquidity of the portfolio and the flexibility the investor has in trading the portfolio.
The investor should also take into account that the option holder may choose to exercise the option early to capture the stock’s dividend, thus care needs to be taken when scheduling the option expiry to account for ex-dividend dates.
It should be noted that brokerages will often require a margin to be posted if the stock option moves heavily into the money despite the fact the investor has the underlying stock to cover the loss. The investor will therefore need to plan for additional capital to meet future margin calls before entering into the covered call.
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