A covered call is a type of options strategy that involves selling a call option on a stock that you already own. A call option gives the buyer the right, but not the obligation, to buy the stock from you at a specified price (called the strike price) before a certain date (called the expiration date). By selling a call option, you receive a premium from the buyer, which is your maximum profit potential if the option is exercised. However, you also limit your upside potential if the stock price rises above the strike price, because you have to sell your shares at that price to the buyer. You also have to deliver your shares to the buyer if they exercise their option.
A covered call is a neutral to bullish strategy, meaning that you expect the stock price to stay below or near the strike price until expiration. This way, you can generate income from the premium and reduce your downside risk by owning some shares of the stock. However, if the stock price rises significantly above the strike price, you may miss out on some of the gains and have to sell your shares at a lower price than what they are worth in the market.
A covered call is suitable for investors who have a short-term neutral view of their stock and do not expect it to appreciate much in value in the near future. It can also be used as a way to lower your portfolio volatility and improve your returns by collecting premiums from selling options. However, it also involves some trade-offs and risks that you should be aware of before using this strategy.
Basic Theory:
A covered call involves two main components: owning a certain amount of a stock and selling call options on that stock. The investor generates income from the premium received for selling the call option, which provides some downside protection as the premium offsets potential losses in the stock’s value. However, the investor forgoes unlimited upside potential in exchange for the premium received.
Procedures:
- Selecting the Stock: Choose a stock that you are comfortable holding in your portfolio for the long term. It’s essential to have a bullish or neutral outlook on the stock.
- Identifying the Call Option: Sell call options against the stock you own. Choose a strike price and expiration date based on your market outlook and risk tolerance.
- Calculating Return Potential: Determine the potential return by adding the premium received from selling the call option to any potential capital gains in the stock.
- Monitoring the Position: Keep a close eye on the stock’s performance and be prepared to manage the position based on market conditions.
Excel Formulas:
Let’s create an Excel table to illustrate the covered call scenario:
| Stock Price (Initial) | Stock Quantity | Call Option Premium | Strike Price | Expiration Date |
|---|---|---|---|---|
| $50 | 100 | $2 | $55 | 01/31/2024 |
Calculation:
- Potential Return Calculation:
- Total Return = (Stock Price + Call Option Premium) * Stock Quantity
- Total Return = ($50 + $2) * 100 = $5200
- Breakeven Price Calculation:
- Breakeven Price = Stock Price + Call Option Premium
- Breakeven Price = $50 + $2 = $52
Scenario:
Assuming the stock price remains below the strike price ($55) at expiration, the call option will not be exercised. The investor keeps the premium and can repeat the covered call strategy.
Result:
The potential return is $5200, and the breakeven price is $52.
Other Approaches:
- Adjusting Strike Price: If the stock price rises significantly, consider buying back the call option and selling a new one with a higher strike price to capture additional premium.
- Rolling Options: Roll the option forward by buying back the current call option and selling another one with a later expiration date.
- Exiting the Strategy: If the market conditions change unfavorably, the investor may choose to close the covered call position by buying back the call option and selling the stock.
