One of the cardinal rules of investment is fully understanding the terminologies used as well as the strategies implemented. This allows the trader to make sound investment decisions as well as minimise associated risks.
In options trading, one of the strategies used by many seasoned investors is covered calls. But what exactly is a covered call option?
Owning a stock entitles you to several rights. These rights include the option to sell stocks at their current market value any time you wish to. In covered call writing, you are selling to the buyer such a right at a predetermined price prior to the expiry. Essentially, the buyer attains the legal right to purchase shares of the underlying stock at a predetermined price (also called strike price). If you (the seller) own those underlying shares, the options are called covered because the shares are not purchased at an open market and at a predetermined price.
This strategy is viewed by many options traders as conservative strategy. It is particularly beneficial for traders who are bullish or neutral in their outlook on some of the equities in their portfolios. Investors who are looking to trade upside potential for downside protection and those who want to be paid for the assumption of the obligation of selling stocks at a strike price should also consider this strategy.
This strategy can be implemented when you want to produce income from some of the stocks in your portfolio. Other investors utilise this strategy in order to profit from option premium time decay. It is also advantageous to make use of covered calls if you want to keep your stocks for the long-term, either for the dividends or the tax benefits. Some investors who feel that the value of their stocks won’t appreciate or even drop in value opt for this strategy. Finally, a lot of investors who feel that their stocks are overvalued use this strategy to their advantage in order to profit.
It is important to note, however, that this strategy has its risks. If you are going to use this strategy, it is important to hold on to the shares. If you do not, you risk what is called a naked call. In a naked call, the potential for loss increases when the stock increases in value. If such happens, your next recourse would be to purchase back the option position. However, you may suffer some losses, both in terms of cash outlay and profit.