A covered call is when the writer or seller of a call option either owns the underlying security, or has a guaranteed way to obtain it. Investors are able to open a position for another investor to take.
An example of this would be selling a call option. The seller, or “writer,” of the contract is obligated to fulfill the contractual obligation outlined in the call, namely to deliver 100 shares of the underlying stock to the owner of the call option in exchange for the strike price listed in the call contract.
If the writer or seller of a call option does not have possession of the underlying security, this is called a Naked Call, which exposes the investor to unlimited risk and is forbidden by most brokerages. A covered call, on the other hand, is when an investor does keep the underlying security in his inventory just in case the call option on it is exercised.
This can be a good conservative strategy, even though it does limit the investor’s upside potential. Selling call options that never get exercised can be a good means of generating extra income. For an example of what a covered call looks like: let’s assume that you have 100 shares of company ABC, which is trading at $100/share.
You can sell a Covered Call for your position, which means that you take upon yourself an obligation to deliver 100 shares of ABC, which you already have, in exchange for the strike price named in the call contract. You’re “covered” because you already have this position, and don’t need to buy it on the market.
If you sold a covered call with a strike price of $120 and the stock price increases to$150, your 100 shares will be taken away from you, and you’ll receive $120/share. If you received a premium of $5/share on the call contract that you sold, you can add that to your net gains.
If you had bought the stock at $100/share, your net gain per share would be $25. Since options contracts are written for 100 shares at a time, that means you made $2,500. You can see the opportunity cost, though: you could have earned much more if you hadn’t sold the call in this example.
On the other hand, if the stock is trading at $115 at the expiration, both the stock and the premium are yours to keep. In this way you would have maximized your gains on a somewhat stagnant stock. Doing this over and over can have a compounding effect or give you income much like a dividend-paying stock.
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