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Option Strategy – What is a Covered Call?
A covered call is an options strategy for which one needs to hold a long position in the underlying asset, such as a stock while selling the call option on the underlying asset. By selling the call option, the investor generally locks the price in of the asset, to enjoy a short-term profit. Moreover, the investor also gets a slight cushioning from a future decline in stock prices.
When should you use the covered call option strategy?
The covered call works well when the market is neutral or moderately bullish. In such circumstances, the future upside potential of the stock is limited. This strategy is rewarding when the outlook for the stock owned by an investor is not very bright and when short-term profits are a better idea than to keep holding the stock.
How does the covered call strategy work?
For the execution of the call option strategy, one must hold a stock of a company. Let’s assume that investor A already holds the stock of a company i.e. going long. A’s viewpoint when he bought the stock was bullish, but now A’s unsure of the future upward potential for the stock and so A doesn’t expect the price to rise much.
Now, what should A do? A can book a short-term profit and protect himself with a minor downside in the price of the stock by using the call option. And so, A will sell the call option contract of the stock at a strike price that’s above the purchase price of the stock. The buyer of the call would give A a premium, which A is obligated to keep irrespective of whether the option is exercised or not.
Here are the three scenarios that can take place −
Scenario 1 − Stock price goes up In such a situation, since "A" had effectively locked in the sale price of the stock by selling the call option, "A" has a guaranteed short-term profit. In addition to this, "A" also gets the premium the buyer of the call option paid "A". Therefore, it is a good way to opt when the market outlook is positive.
Scenario 2 − Stock price goes down In this scenario, "A" gets limited protection from the downside due to the premium "A" got by selling the call option. This premium amount that "A" has received can be used to decrease the impact of the loss that "A" had to suffer due to the fall in the stock price.
Scenario 3 − Stock price remains the same When the price does not change over time, the profit would actually be the amount of premium from the option sold by "A". It is a situation irrespective of whether the option is exercised by the buyer or not. If the buyer doesn’t want to exercise the option, he/she gets to enjoy the premium as well as hold onto the shares.
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