What is Covered Call in Option Trading| Espresso

What is Covered Call in Option Trading

Any investment requires a great amount of caution. When it comes to trading in options, an investor should be more careful. This is because options trading is riskier than any other equity investment in the share market. Due to this, most seasoned investors always consider different options trading strategies to minimise their losses and curtail the risks involved.

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One of such strategies in options trading is a covered call. If you are not too sure about it, keep reading below.

What is a Covered Call Option Strategy?

The covered call in the options strategy involves a trader selling a call option contract from the stock that he owns currently. The investor usually locks the asset's price by selling the call option, thereby enabling himself to relish a short-term benefit. Besides, the investor can also avail of a little protection from any decline in the stock prices in near future.

Understanding What is a Covered Call

Covered call in an option strategy is a neutral strategy that the investor can use to expect a slight increase or decrease in the stock prices during the entire period of the written call option. Such a strategy is employed when an investor adopts a short-term neutral view of an asset. Due to this, the investor holds the asset for a long period and gains a short position through the option of generating income from the premiums of the option contract.

Simply put, if you, as an investor, intend to hold the underlying stock for a long period but do not expect a higher price increase shortly, you can generate regular income through the premiums for yourself while waiting out the lull in the market. The covered call strategy will serve as a short-term hedge and allow you to earn income through the premiums received for writing the option contract.
Also Read: Bear Put Spread Strategy in Options Trading

Benefits of Covered Call Option Strategy

Investors can gain three potential benefits out of the covered call strategy in an option contract. They are as follows:

1. Premiums can act as income: Several investors often use covered calls for earning a regular income from the premiums. They also sell the covered call strategies regularly, intending to add more percentage points in the income on their annual returns.

2. Investors can get limited amounts of downside protection: The investor's premiums by selling a covered call option strategy will only be a small fraction of the stock prices. Hence, the protection is very limited. However, the premiums received per share will reduce the break-even point of owning the stocks, reducing the risks.

3. Investors can get cash up front: For an investor, cash now is much better than cash later. Hence, the investor can get cash at the beginning of the stock market transaction by selling a covered call strategy. The investor could use this cash to advance additional interests elsewhere. This upfront cash payment basically acts as a lower entry point in the equity market.
Also Read: How to invest in Stock market?

How Covered Call Strategies Work?

As an investor, if you wish to utilise a covered call option strategy, you will be required to own the stock of a business first. So, if you already have the stocks of an organisation, it might be the case that when you bought it, the market was bullish. However, with time, you are not sure of the stock's future potential in the market, and therefore, you do not expect its price to rise much.

In such a situation, what should you do? You can protect yourself by booking a short-term profit using the covered call in the option contract of the stock. So, you can sell the option contract of that stock at a price that's higher than your purchase price of the same. The buyer of your covered call strategy would give you a premium in return. This way, you will not be obligated to retain the option for future exercise.

Conclusion

One of the biggest benefits of the covered call option strategy is that you will not have to time buying the stock and selling the covered call option contract. It will be upon you to sell the covered call option at any point in time after you have bought the stock. It is always a good idea to be cautious when dealing with the covered call option strategies, as there are some risks involved.
Also Read: About Futures Contract

 

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Frequently Asked Questions

Covered calls are usually low-risk investments. Covered calls in the option contract, however, would limit the additional upside profit potential once the stock price continues to rise, and would not protect an investor much from a drop in the price of the stock.

 

It is also known as a ‘buy-write’ strategy and is basically a two-part strategy where a stock is purchased and the covered calls are sold as per the share-for-share basis.