When it comes to investing, covered calls are a popular strategy that can help investors earn extra income while reducing risk. But what exactly is a covered call? In this article, we explain how covered calls work, their benefits and drawbacks, and answer common questions about this investment approach.
What is a covered call?
A covered call is a strategy that combines owning stocks with selling call options. This approach allows investors to make money by collecting a premium from selling the options while still holding their shares.
Here’s how it works:
- Owning the stock (the “covered” part): Suppose you own shares of a company called “ABC Corporation.” You believe the stock has potential for growth but want to earn extra income while you hold it.
- Selling call options (the “call” part): You sell a call option, which gives another investor the right (but not the obligation) to buy your ABC Corporation shares at a fixed price (the “strike price”) before a specific date (the “expiration date”).
- Why do buyers purchase call options? Investors who buy call options believe that ABC Corporation’s stock price will rise. If it does, they can buy your shares at the lower strike price and make a profit.
- What do you gain? As the seller, you receive a premium (a cash payment) for selling the call option. This income is yours to keep, no matter what happens to the stock price.
- The trade-off: If ABC Corporation’s stock price rises above the strike price, you must sell your shares at the agreed price, even if the market price is higher. This means you may miss out on further gains.
Since you already own the stock, this is considered a “covered” call, meaning you are not taking on excessive risk.
Pros and Cons of Covered Calls
Like any investment strategy, covered calls have both benefits and drawbacks. Let’s take a closer look.
Pros:
- Earn extra income – Selling call options lets you collect premiums, providing immediate income on your investments.
- Boost portfolio returns – If the stock price stays below the strike price, the option expires without being exercised. You keep both your shares and the premium, increasing your overall returns.
- Reduce risk – The premium you receive can help offset small losses if the stock price drops, giving you some protection against declines.
- Steady cash flow – Regularly selling call options can create a consistent income stream, making covered calls attractive to investors looking for steady earnings.
Cons:
- Limited profit potential – If the stock price rises above the strike price, you must sell your shares at that price, even if the market price is much higher. This means missing out on larger gains.
- Stock ownership risk – If the stock price drops significantly, the premium you earned may not be enough to cover your losses.
- Commitment to sell – Once you sell a call option, you are obligated to sell your shares if the buyer chooses to exercise the option. This limits your flexibility.
Common questions about covered calls
Is a covered call strategy good for conservative investors? Yes, covered calls can be a good choice for conservative investors. They provide extra income while limiting risk, making them a safer options strategy compared to others.
What happens if the stock price goes above the strike price? If this happens, you must sell your shares at the strike price. While you may miss out on additional gains, you still keep the premium you received for selling the option.
Can I buy back the call option after selling it? Yes. If you want to keep your shares, you can buy back the call option before it expires. However, if the stock price has gone up, you may have to pay more than what you received initially.
Can I sell a covered call if I don’t own the stock? No. Most brokerages require you to own at least 100 shares per options contract before selling a covered call. Selling calls without owning the stock is called “naked selling,” which is riskier and usually requires extra money in your account as a safety measure.
