Professional traders have been using the covered call option to boost their market income for a long time. There’s no reason why individual investors cannot use this conservative but effective covered call strategy by learning how it works and how to use it at the right time.
Let’s explore what a covered call option is and how you can use the covered call strategy to lower your portfolio risk and improve your company’s return on investment.
What Is a Covered Call Option?
A call option is a contract that offers the buyer the right to purchase a predefined quantity of the underlying stock at the fixed strike rate any time before expiration. The buyer has the legal right to buy the shares or futures contracts but is not obligated to do so.
The journey from naked to covered call option is based on whether the seller owns the security or not. The option is considered “covered” when the seller already holds the asset and can deliver the instrument directly if needed.
As a stock owner in the market, you are basically entitled to several rights, including the right to sell securities at the market price at any time. Writing a covered call option effectively sells this right to some other trader for a fixed and non-refundable premium amount. The buyer, in turn, gets the right to own your asset at a predetermined strike rate on or before the expiration date.
See the payoff graph of a covered call option strategy from Investopedia:
How Does a Covered Call Strategy Work?
A covered call strategy is an investment option that allows selling the covered call option against stocks you already own to generate additional income. The extra gain is collected in the form of a premium amount that you get to keep, irrespective of whether the buyer exercised his right to acquire or not.
Often considered low-risk as compared to others, the covered call strategy is one of the most popular methods among traders to generate extra income from their investment portfolios. Since the potential risks are limited, most brokerages allow selling the covered call option even through accounts that are not authorized to trade in other options.
A covered call strategy involves the following two steps:
- Buying Shares – The first step involves purchasing shares of stock, and that requires your due diligence. You can use any method like a covered call stock screener to choose the preferred stock. Just keep in mind that a covered call strategy works best for non-volatile assets with a stable price.
- Selling Options – Now that the purchasing part is over, you can start selling the covered call option against your owned stock. The buyer will have to pay you a premium amount for the right, but not the obligation, to acquire the shares at the fixed strike rate before the expiration date. Before you start selling, it is advisable to use a covered call screener to decide which options are worth betting on.
I believe that the covered call strategy can prove to be a great source of extra income for traders, but only if you are ready to risk losing the underlying stock. Therefore, you should think long and hard before writing a covered call option against some incredible assets that you may want to hold on to in the long run.
With a poorly executed covered call strategy, the worst-possible scenarios are either you have to sell owned shares, or your shares lose all their value. In both cases, the potential for loss is limited by the premium account and the fact that the option is “covered.” Some of the other types of options can expose you to potentially infinite loss.
A covered call strategy does not just protect you from losing capital but also places a limit on how much you can gain from the increase in stock price. In exchange, you can keep selling the covered call option on the same shares and receiving premium amounts if the buyer does not exercise his call option.
Also Read: Types of Options In Derivatives Trading
Pros and Cons of Covered Call Strategy
The advantages of selling a covered call option far outweigh its associated risks. It is a much better option for budding investors than simply holding the stock, as it can help offset downside risks and add to the upside returns. In simple words, the covered call strategy allows the seller to make more money or lose less capital than making naked calls. Here, I have explained the potential benefits in detail below:
Generate Additional Income
As soon as you sell a covered call option, the buyer has to pay you a non-refundable premium amount which is yours to keep no matter what happens in the market. For traders who want to make extra income from their investment portfolio, using a covered call option screener is a great idea to stay ahead of market trends.
Target The Stock Selling Price
Using a covered call option allows you to target a higher stock selling price than the current market cost. If you want to sell a stock at a higher price than the current market value, a covered call stock screener can help you target that objective even if the asset value never rises that high.
Limited Downside Risk Protection
Let’s assume the worst-case scenario where the stock value drops to zero and the shares are effectively worthless. The potential risk in a covered call option is still limited and finite as opposed to other options strategies that may expose you to infinite losses.
Apart from all the pros of using a covered call strategy, some potential risks are also associated with it. Here, I have also explained the cons in detail below:
Limit Potential Gains
The premium received at the time of selling the covered call option plus the difference between the strike rate and the current stock value is the most you can make with a covered call strategy. The potential gain is also limited by the fact that you will gain nothing even if the present share value went beyond the strike price.
No one can know precisely what the future may hold; circumstances can make you want to sell off some of your investments suddenly. The covered call strategy requires you to own the underlying shares until the covered call option expires. You may have to hold on to the shares for much longer than you expected to ensure that the option remains covered.
Capital Gains Taxes
Another significant downside of using the covered call option is the short-term or long-term capital gains taxes you may have to settle. These taxes are based on several factors that affect your whole covered call strategy.
Things To Consider For Individual Investors
Now that you have learned so much about the covered call strategy and are getting ready to jump into the troubling waters of options trading, it is time you get answers to some questions honestly to determine whether you are ready or not. You should also consider using a covered call option screener to assess the various securities and their future benefits.
Will you risk owning the stock if the price falls?
Since the most crucial part of making a covered call strategy is the underlying stock, the risk of losing money is considerable if the stock price falls below the breakeven point. Hence, it is always considered a good idea to focus on quality stocks that you are willing to hold on to in the long run.
Will you risk selling the stock if the price soars?
The covered call option involves the obligation to sell your stock at the strike price within the expiration period. You will have to think really hard about that obligation, primarily if the stock has been owned by you for years or you want to own it for more time. Therefore, investing in a covered call strategy tied to a stock wherein you are emotionally connected is generally a bad idea. There also lies the risk of triggering a substantial tax liability if you are obligated to sell a stock with a sizable unrealized profit.
Will you be satisfied with limited and if-called gains?
It is general knowledge among traders that some calls will offer higher fixed return profits as compared to other call options that follow a reverse trend. You can use any covered call screener in the market to predict the profit pattern before investing in a covered call strategy. There is no fundamental correct answer as this question can only be answered based on the personal preferences of individual investors.
Selling a covered call option is a successful strategy among long-term investors who desire additional returns from their holdings. The solution to achieving considerable gains in a covered call strategy is to select the right company and then decide on a reasonable strike rate. A covered call option screener can help you with that.
So if you’re ready to dive into options trading, the covered call strategy is a safe and great way to begin. Just remember that this game is highly complicated and not everyone’s cup of tea. Hence, using a covered call stock screener to weigh your risk appetite is recommended before making any decisions.
Adrian Collins works as an Outreach Manager at optionDash. optionDash is always looking forward to offering the best covered call and cash secured put screener on the internet. Adrian is passionate about spreading knowledge on stock and options trading for rising investors.