What is Covered Call Strategy? A Detailed Guide on Covered Call Strategies
Meaning, Objectives, Features and Benefits of Covered Call Strategy
Experienced investors use various options trading strategies on the Options trading app to maximize their profit and mitigate risks. One of the most effective options strategies that veteran investors use is the covered call. If you are wondering what a covered call option strategy is, how it works, and what its benefits are, then here we explain everything you should know about it.

What is a Covered Call Strategy?

The term 'covered call' refers to a financial transaction in which investors sell call options. In a covered call strategy, the investor sells a call option contract and locks in the price of the asset. The investor who holds a long position sells call options to generate some income, and the trader or investor can make most of the short-term profit. Also, this protects the investors from any decline in stock prices of the asset in the future.

A covered call is a popular options strategy that generates options premiums for investors. Though the stock price may increase or decrease slightly when the investors execute a covered call, it can bring significant profit to the investors dealing in volume. Investors who aim to hold the underlying stock and do not foresee a price increase in the future execute such a strategy.

Understanding The Basics of the Covered Calls

A covered call is also identified as a two-part strategy, where the stock is bought, and calls are sold. You must know about a popular term called - "buy-write". It means buying a stock and selling the call simultaneously. There is another term you must know about - "overwrite". This term means selling the call against the stock you bought before. Also, when the shares are bought before the calls are sold or bought simultaneously, that position is called a "covered call position." Options Strategy Builder can help you know more terms. 

The neutral strategy of covered call brings a minor increase or decrease in the stock price. So, the investor with a short-term neutral view of the security holds the asset and later generates income from the option premium. In other words, a covered call strategy acts like a short-term hedge on a long stock position. It allows the investors to earn income as a 'premium'. However, it is also important to note that the investor loses any gains if the price becomes higher than the option's strike price.

Maximum Profit and Maximum Loss

You must know that the maximum profit of a covered call is the premium you get after selling the options sold and the stock increase between the stock's current price and the strike price. The maximum loss is the stock's selling price, less the premium. You will get the premium for the options sold if the stock becomes zero.

Benefits of Covered Calls

Here are the benefits of employing a covered call strategy:

Reliable Premiums

An options writer generates income by selling a covered call. However, they can lose the potential profits, too. The writer must produce 100 shares for the contract when the call expires. They must buy in the open market without sufficient shares, which can lead to more money loss. Many investors use covered calls in Options Bot Templates on a regular basis because they can generate income through the premium received from selling the call. Some do it monthly, while some quarterly, intending to add cash income points to their annual returns.

Limit Losses

Covering calls can limit maximum losses and possible profits. One of the most useful strategies for institutional funds and traders, this covered call strategy lets them quantify their maximum losses. This is why investors sell covered calls and get some downside protection. The premium received can lower the breakeven point of holding the stock and lower the risk. Also, note that the premium received from selling a covered call is meager. So, the protection is also limited.

Loss of Potential Upside

A covered call strategy does not work for very bullish and bearish investors. A bullish investor is better when they don't write the option and hold them. In case of an increase in the stock price, the option caps the profit on the stock, lowering the overall trade profit.

Risks of Covered Calls

These are the two main risks of the covered call strategy.

Losses Due To The Stick Price Decline Below The Breakeven Point

You will experience the biggest risk of losing money if the stock price goes lower than the breakeven point. Do you understand what the breakeven point is? Well, it is the security's purchase price, from which the received option premium is deducted. Whenever there is stock ownership, there is always a chance of risk. Stock prices can become zero, which is the entire amount invested, so covered call investors must know the associated stock market risk.

Opportunity Risk

This is another risk when you don't participate in a large stock price increase. The holder must sell the stock according to the current strike price when the covered call is open. Though there are chances of earning a premium or profit when it rises above the strike price, that profit potential is limited. The covered call writer hardly participates in a stock price gain. When there is a large stock price rise, covered call writers can rather miss that opportunity.

A covered call works best for neutral-to-bullish market scenarios. Investors must know that the profit potential is limited, and there is risk of stock ownership below the breakeven point. Therefore, before investing, investors must understand that covered options limit the risks and potential downsides, but the option writers can earn a premium from a small price spike.

When to Use and Not Use Covered Calls?

The best time to sell covered calls is when the stock has good or neutral long-term prospects and there is little likelihood of huge gains or losses. The call writer will be able to generate a lucrative premium. It is also essential to know that the covered call is not a good strategy when there are big chances of large price changes in the stock. When the price rises than expected, the call writer will not profit above the strike price. In the case of dropping the stock price, the options writer can lose the entire price of the security and initial premium, too.

Wrapping Up

Like any other trading strategy, even covered calls may or may not bring you significant gains. The maximum payoff from a covered call will happen if the stock price rises to the sold strike price. This way, the investor can make income from the little rise in the stock.

They can get a full premium for the option. When a covered call is used in the right stock, it can generate income for you. Covered calls are also considered risky, though the risk is very limited. Covered calls can limit further upside profit potential when the stock increases and may not protect much from decreased stock price.

To make a covered call, sell some of your securities at a pre-fixed price in the future. This strategy is best for investors who want lower upsides and lower risk. Use Custom Trading Algo Development to automate your trading and have a thriving trading technology landscape.


Prachi 30 April, 2024
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