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The News God > Blog > Tech & Autos > What Are Covered Calls and How Do You Invest in Them?
Tech & Autos

What Are Covered Calls and How Do You Invest in Them?

Rose Tillerson Bankson
Last updated: March 22, 2023 5:54 am
Rose Tillerson Bankson - Editor
March 9, 2023
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What Are Covered Calls and How Do You Invest in Them?
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Covered Call Writing

When the market is bullish or trading in a limited range, covered call writing can be a profitable technique.

Contents
Covered Call WritingUsing Covered Calls StrategicallyIs there any chance of losing money?How far in the future may I sell covered calls?

One type of covered call option trade involves selling out-of-the-money call options in conjunction with an existing stock investment. The risk of appreciation on these short calls is offset by an ownership stake in the underlying stock. This means the call writer’s downside is limited to the value of the underlying stock and not the value of the short calls.

Using Covered Calls Strategically

It is possible for any stockholder to write one covered call option contract for every 100 shares of stock they possess. This is a strategy for supplementing one’s income by collecting option premiums on existing holdings. The value of the underlying shares could fall below the option premium paid before the option expires, which would be a loss for the covered call writer. The investor will not be exposed to the call option’s upside risk if the stock is called at a price above the covered call’s strike price.

All future appreciation in the stock goes to the covered call buyer, while the call writer keeps only the premium paid for his or her shares. The covered call writer is entitled to any profits before the short call arrives in the money.

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Whether or whether the covered call options expire in the money, the writer keeps the premium received. The option writer can cover the short position by purchasing the call options and then writing a call on the underlying stock before they expire. If the stock price of the underlying asset doesn’t decrease by more than the call option’s strike price, the option seller will profit from the daily theta decay.

Protecting against a drop in the value of the underlying stock, a covered call option’s premium falls as it moves further out of the money in reaction to a fall in the stock price. A covered call writer’s goal is to sell a call option with a strike price higher than the price at which the underlying stock is trading.

The goal of the covered call option strategy is to keep the stock position and keep all of the premium received from selling the option before it expires worthless. This paves the way for the writing of several calls on the same stock, with the premiums from each call being sufficient to pay for the shares and generate income.

In addition, covered call options can be utilized to sell stock at a predetermined price. The covered call writer’s plan is to collect the premium, then sell the stock at the option’s strike price when the stock price reaches its objective.

When writing covered calls, the risk is highest for equities with little volatility, both based on fundamentals and technicals. When stock market volatility is minimal, investors face less danger when hanging onto their investments. The primary risk associated with covered calls lies in the underlying security. Trading with low bid/ask spreads and high liquidity is recommended while using option chains. A covered call option should be repurchased when its value has declined considerably and the risk-to-reward ratio no longer supports further decline in the premium. The goal of a covered call option deal is to profit from stock that the trader plans to keep for the long term.

Is there any chance of losing money?

The covered call option strategy will be unprofitable if the stock price falls before expiration below the value of the short call option. Hence, you would lose money on the play. Yet, selling a call option results in more financial gain. It is the stock itself that carries the risk of the options deal, since it is being utilized to hedge the risk of the short call option. Even if the covered call is deep in the money, resulting in the loss of some capital gains on the stock and the shares being called away, there is still a chance of making a net profit on the call option price.

How far in the future may I sell covered calls?

If a call option is sold further out, the buyer receives a larger amount of time value, but the option’s value will decrease more slowly because it has more time to get in the money.

To maximize premium and reduce time decay, selling covered calls between 30 to 45 days of expiration is optimal. You need to sell a contract with a substantial premium on it in order to make the option play worthwhile. It is common practice to sell covered calls at a discount of 2% to the underlying stock price.

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