Covered calls is the name of an options strategy. In the case of a share investor, it involves both owning shares and selling call options over those shares. The main benefit of the strategy is that it generates income for the investor via the sale of the options.
The sale of the options exposes the investor to risk. That risk is offset by the investor already owning the asset underlying the options. This ownership of the underlying assets is said to cover the call options.
Based on this call option strategy, an investor owns shares and then sells call options over those shares. The options sale generates income. If the share price goes up and triggers exercise of the call options, the share investor is already covered, or protected, by the prior ownership of shares. The investor benefits both from the increased share price and the option income.
The strategy is a buy-write (buy-sell) strategy. An investor buys shares and writes (sells) the call options knowing the shares protect against the call risk of the options. The strategy is based on an investor having neutral or negative price expectations regarding the underlying shares.
For example, let us say that the investor purchases one thousand shares in the ABC Company at ten dollars per share. The investor believes the short term prospects for this firm are at least neutral and possibly negative. In other words, the share price of the stock is expected to stay relatively constant or possibly decrease.
Following purchase of the shares, the share investor sells one hundred AAA Company call options for one dollar an option. The options have a one hundred dollar strike price and one month expiry. This option sale generates income of one hundred dollars.
From this position, one of three outcomes will unfold regarding the ABC stock price. First, it will remain flat within the ten to eleven dollar range. Second, it will fall below ten dollars. Third, it will rise above eleven dollars.
In the first two scenarios, the share options expire worthless without their owner making a call on the shares. In both these cases, our investor continues to own the XYZ shares as well as generating a three thousand dollar income from the option sale.
The third scenario triggers exercise of the call options. Our investor is therefore obliged to sell ten thousand XYZ shares. Total income for the investor is sixty thousand dollars from the share sale as well as three thousand dollars of options income.
In conclusion, covered calls are a low risk way to generate some income on the back of stock ownership. Selling call options does cap the upside an investor can reap from the sale of stock. However, this cap can be varied at the discretion of the investor according to call option strike price selected buy the investor.
Looking for more info on the low risk options strategy known as covered calls? Get the low down instantly in our guide to all you need to know about call strategy .