What Is a Covered Call in Stocks?
What Is a Covered Call in Stocks?
A covered call is an options strategy that involves selling call options on a security that the investor already owns. It is considered a conservative strategy that offers potential income, while also providing downside protection.
How Does a Covered Call Work?
When an investor sells a covered call, they are giving someone else the right to buy the underlying stock at a specific price (known as the strike price) within a certain time frame (known as the expiration date).
In exchange for selling the call option, the investor receives a premium. This premium is the income potential of the covered call strategy.
If the stock price remains below the strike price at expiration, the call option expires worthless and the investor keeps the premium. However, if the stock price rises above the strike price, the investor may be required to sell their shares at the agreed-upon price.
Example of a Covered Call
Let’s say an investor owns 100 shares of XYZ Company, which is currently trading at $50 per share. The investor decides to sell a covered call by selling a call option with a strike price of $55 and an expiration date one month from now.
The investor receives a premium of $2 per share, or $200 in total ($2 x 100 shares). If at expiration, the stock price is below $55, the call option expires worthless and the investor keeps the $200 premium.
However, if the stock price rises above $55, the investor may be required to sell their shares at that price. While the investor would miss out on any additional gains above $55, they still keep the premium received from selling the call option.
Advantages of Covered Calls
- Income generation: Selling covered calls can generate additional income for investors.
- Downside protection: The premium received from selling the call option provides some protection against price declines.
- Flexibility: Investors can choose their own strike price and expiration date to suit their individual investment goals.
Disadvantages of Covered Calls
- Limited upside potential: If the stock price rises significantly, the investor may miss out on higher gains above the strike price.
- Obligation to sell: If the stock price exceeds the strike price, the investor may be obligated to sell their shares.
- Market risk: Covered calls are subject to market fluctuations and the potential for losses.
Frequently Asked Questions (FAQs)
- Is selling covered calls risky?
- What is the maximum profit potential of a covered call?
- Can a covered call be bought back?
- Can covered calls be used with any stock?
- What happens if the stock price falls below the purchase price?
- How are covered call profits taxed?
- Can covered calls be used in a retirement account?
- What is the difference between a covered call and a naked call?
- Are covered calls suitable for all investors?
- Can covered calls be combined with other options strategies?
Selling covered calls involves some risk, as the investor may be required to sell their shares if the stock price rises above the strike price. However, it is considered a lower-risk options strategy compared to other strategies like naked calls.
The maximum profit potential of a covered call is the premium received from selling the call option. If the stock price remains below the strike price at expiration, the call option expires worthless and the investor keeps the premium.
Yes, a covered call can be bought back by the investor at any time before expiration. This would effectively close the position and eliminate any further obligations or potential gains.
Covered calls can be used with any stock that has options trading available. However, it is important to consider the liquidity and volatility of the stock when implementing a covered call strategy.
If the stock price falls below the purchase price, the investor may experience a loss on their shares. However, the premium received from selling the call option can help offset some of the losses.
Profits from covered calls are generally taxed as short-term or long-term capital gains, depending on how long the investor held the underlying shares. It is advisable to consult with a tax professional for specific tax advice.
Yes, covered calls can be used in a retirement account, such as an IRA. However, it is important to ensure that the specific retirement account allows for options trading and to adhere to any account restrictions or regulations.
A covered call involves selling call options on a security that the investor already owns, providing downside protection. A naked call, on the other hand, involves selling call options on a security that the investor does not own, which exposes the investor to unlimited risk if the stock price rises.
While covered calls can be a viable strategy for many investors, it is important to consider individual risk tolerance, investment goals, and market conditions. It is advisable to consult with a financial advisor before implementing any options strategy.
Yes, covered calls can be combined with other options strategies, such as buying protective puts or creating a collar strategy. These combinations can help further mitigate risks or enhance potential returns, depending on the investor’s objectives.
A covered call is an options strategy that can generate income and provide some downside protection for investors. By selling call options on a security they already own, investors can receive a premium while potentially limiting their losses if the stock price falls. However, it is important to understand the risks involved and consider individual investment goals and market conditions before implementing a covered call strategy.