Understanding the Purpose of a Covered Call Strategy
A covered call is a valuable investment strategy employed by experienced investors to generate additional income from their stock holdings. In this article, we will delve into the intricacies of this strategy, discuss its advantages, and provide you with a comprehensive understanding of when and how to implement a covered call.
What is a Covered Call?
A covered call is a strategy utilized by an investor who owns a stock and sells call options on that same stock. Essentially, the investor sells the right, but not the obligation, to the buyer of the call option (also called the option holder) to buy the underlying stock at a predetermined strike price by a certain expiration date. This strategy is described as ldquo;coveredrdquo; because the investor already possesses the relevant shares needed to fulfill the contractual obligation if the option is exercised.
The Benefits of the Covered Call Strategy
Income Generation
The primary benefit of a covered call is the generation of additional income. Even if the stock price remains within a range, the investor can still earn premium from the sale of call options. This is particularly appealing for conservative investors who wish to enhance their returns on a specific stock position.
Profit Potential
The covered call strategy allows for potential profit generation in various market conditions. For instance, if the stock price rises significantly above the strike price (rendering the option ldquo;in the moneyrdquo;), the option holder will execute it, and the investor will sell the stock at the strike price. The premium earned from selling the call option is added to the gain from the sold stock, providing a doubled benefit.
An Example of a Covered Call Strategy
Let's explore a practical example to illustrate the concept of a covered call strategy.
Scenario 1
Imagine a scenario where an investor, A, purchases 100 shares of XYZ stock at a price of $50 per share on June 1. Simultaneously, A sells a call option with a strike price of $55 expiring on June 30. The premium for this call option is $4 per share.
Outcome Analysis
If the stock price on June 30 is $60, the call option will be exercised, resulting in the investor (A) selling the stock at $55. The investor's profit calculation would be as follows:
Total Capital Gain: $10 (since the stock price increased from $50 to $60)
Option Premium Collected: $4 per share (100 shares * $4 per share $400)
Net Profit: $10 (capital gain) $400 (premium) $1,010 or $10.10 per share
Alternative Scenario
If the stock price on June 30 is still below the strike price of $55, the option will not be exercised. In this case, A will keep the premium collected, and can write another option for the following expiry period.
When to Use a Covered Call Strategy
The covered call strategy is particularly suitable for investors holding stocks that are unlikely to experience a rapid price increase. This includes stocks like banks or utilities that offer dividends but have stable price movements. Additionally, it is ideal in periods when a stock has already experienced a significant rise and is consolidating its gains before the next growth phase.
Practical Example
Consider an investor who buys 100 shares of Nike at $169.10 per share on a given day. They then sell a covered call for 100 shares to sell at $210 per share on December 17, 2021. Although the investor does not expect the stock price to reach $210, should it do so, they will willingly sell their shares to the buyer. The buyer will pay the investor a premium of $0.705 per share, totaling $70.50 upfront. If the stock price reaches $210 or higher on December 17, the option will be exercised, and the investor will sell their shares at the strike price, pockets the premium, and the cycle can repeat for future expiries. If the price does not reach $210, the investor keeps the premium and can write a new option for an upcoming expiration period.