The Covered Call is a type of options strategy that involves selling a call option or the contract between a buyer and a seller, also referred to as the holder and the writer, respectively.
A call option is basically the contract between a buyer and a seller to security. Both parties agree to a certain price, called the strike price, and the expiry for the trade to be executed. In this scenario, the buyer has the right to buy the security but can withhold from buying if he chooses to.
The seller is obliged to write the asset at the agreed strike price, regardless of its underlying value, rises in the market. However, the seller is also entitled to premium, which is a fee paid by the buyer to the seller for accepting the risks accompanied to selling options.
In a covered call, it basically means selling the call option, or the right to sell the asset, to somebody else.
Understanding Covered Call Options Strategy
To understand this strategy, we will have to look at it from two perspectives:
As the buyer, you obtain the right to buy the asset and to refrain from it. Naturally, you will only buy it if you are profiting from it. The buyer will usually refrain from pursuing the transaction if the asset’s underlying value is cheaper than the strike price since you can buy it in the market instead. However, even if you do not proceed with the transaction, you are still obliged to pay the seller premium.
As the seller, it is your responsibility to study your security ahead of setting the strike price. You must limit its upside potential and study how it is faring in the market. You will only gain once the buyer proceeds with the transaction, and only through the difference between the strike price and the asset’s price from which you bought it. Aside from this, you are entitled to the premium fee. Your downside potential must also be limited, with possible losses not exceeding the price you initially paid the security for.
Applying Covered Call Options Strategy
Before you sell a call option, set the strike price just above a price point that you trust the asset won’t exceed. It is helpful if the market moves slowly towards this price but not exceed it. The buyer will not push through with the transaction if the asset’s underlying value does not exceed the strike price. But he would still have to pay you premium. It means you gain and still keep the asset. But if the asset’s value does top the strike price, the holder will proceed with the transaction, profiting from the covered call, while you end up with losses.
Technically, you can sell a security at any time you want, so only use covered call during market inactivity or when compensating losses. Selling a call option means selling the right to sell the security to somebody else. If the security’s market value tops the strike price, the holder will exercise it, leaving you with no other choice but to let go of the asset.