Covered calls refer to monetary value transactions where an investor sells call options that are equivalent to the amount of underlying security. Covered calls can also refer to strategies of investment that are designed to manage risk.
How a Covered Call Works
A covered call happens when an investor takes two concurrent positions. They then buy shares of stock and sell call options on an equal number of shares in the stock.
In the call option, the party that purchases the option has the right, but not obligated, to buy the asset at the set price on the given date.
An investor will buy shares in a covered call then open a call contract to cover the shares. This spreads the risk on the investor’s initial stock purchase because if anything happens, they will keep the fee they made from selling the option contract.
If stock prices go down, losses will be offset by this fee. If share prices reach the option contract price, the investor will sell at that price despite how much higher the stock will go.
Expenses for the contract are always fixed upfront.
Advantages of Covered Calls
Covered calls have several advantages over pure stock. They include:
Investors have the option of striking their prices and letting the market decide their worth. Call writers set their expiration times and let the market decide the value. When it comes to options, you can easily choose the values they will operate; hence they offer unique positioning abilities.
Buy Back Ability
Options of a similar are considered equal, and they can be offset. If an option was to drop, the investor could take the profits then by buying at the then market price instead of waiting for the transaction to pan out. By doing this, the investor will have the shares at the price he was originally willing to pay while also gaining when the market was on a downward trend.
Cash Up Front
As always, cash now is always better than cash later. The sale of a covered position will mean that the investor will get cash at the beginning of the transaction to gain interest elsewhere. Upfront payments act as an entry into equity positions from a lower entry point.
Decay of Time Value
When the buyer uses the option to his right, the time cost is carried at the transactional value. If an option were to trade at a particular cost right now, the value of the short position would be less than it was a few months back, meaning it would be of advantage to the covered call holder.
Low Entry Costs
Investors can significantly lower their entry cost into the underlying equity position by using the covered call strategy. This will be due to the call writer collecting a premium that is deducted against the cost basis of the shares. An investor is always guaranteed a lower entry cost than the current cost price.
Covered calls allow investors to create their yield while settling for stable returns. Investors should view covered calls as income assets rather than equity investments. Investors can get substantial short-term gains through premiums by meddling with strike prices and time. Options work best where investors have an active open market.