• BREAKING NEWS: Bank Rally Fuels Broad-Market Gains Midday
 
SIR Logo
  • About Us
    • Who We Are
    • About Bernie Schaeffer
    • Our Newsroom
    • FAQ
    • Contact Us
    • Corrections
    • Ethics & Fact Checks Policy
  • Market News
    • Sign Up for Free Market Newsletters
    • Opening View
    • Midday Market Check
    • Market Recap
    • View All Free Subscriptions
    • Schaeffer's Volatility Scorecard
    • Featured Publication
    • From the Top
    • Monday Morning Outlook
    • Indicator of the Week
    • Editor's Picks
    • View All
    • Trading Analysis
    • Best & Worst Stocks
    • Earnings Preview
    • Investor Sentiment
    • Quantitative Analysis
    • Technical Analysis
    • VIX & Volatility
    • View All
    • Stock Options
    • Intraday Options Activity
    • Most Active Options
    • Trade Postmortems
    • Options Recommendations
    • View All
    • Trading Education
    • Strategies & Concepts
    • Expectational Analysis
    • View All
    • Market News
    • Buzz Stocks
    • Stocks on the Move
    • Analyst Update
    • 5 Minute Market Rundown
    • Stock Market Podcasts
    • View All
    • Daily Market Newsletters
    • Opening View
    • Midday Market Check
    • Market Recap
    • View All
  • Premium
    • All Trading Services
    • Most Popular Services
    • Elite Trader
    • Quick-Hit Trader
    • Lightning Trader
    • Ultimate Trader
    • View All
    • Directional Trading
    • Options Under $5
    • Leverage
    • Weekly Options Trader
    • Event Trader
    • PowerTrend
    • Schaeffer's Players
    • Overnight Trader
    • View All
    • Advanced Trading Alerts
    • Wealthbuilder
    • Premium Trader
    • Hedge Hunter
    • Volatility Trader
    • Weekly Volatility Trader
    • View All
    • Weekend Alert
    • Weekend Player
    • Weekend Trader
    • Weekend Trader Alert
    • Expiration Week Countdown
    • Weekly Options Countdown
    • View All
    • Newsletter Trading Services
    • Master Portfolio
    • The Option Advisor
    • Schaeffer's Daily Bulletin
    • View All
    • Courses & Education
    • Getting Started with Options
    • View All
  • Options 101
  • Deals
    • Deal of the Week
    • Broker Center
    • Free Trial
  • Log-In
  • Search
>> PODCAST: tastylive's Jermal Chandler makes sense of the stock market<<

Covered Call
Outlook: Short-term neutral, longer-term bullish

The covered call strategy is not a hedged play in the most traditional sense of the word. Instead, it's more accurately described as a way of generating income on a stock investment that might not be living up to your short-term expectations. In this scenario, in fact, the "hedge" is the asset you already own -- namely, shares of any given optionable stock.

In this strategy, a shareholder sells (or writes) a call option against one of his or her stock investments. To ensure all of the calls are "covered," as opposed to "naked," no more than one call option is sold per 100 shares of stock.

The sale of the covered call(s) immediately generates a premium payment for the seller -- which is the maximum reward on the options trade, should the calls expire worthless. And even if those calls move into the money by expiration, the trader already has sufficient stock on hand to meet any assignment obligations.

To examine how the covered call works, let's check out an example.

Entering the Trade

Stock XYZ has been a solid addition to your portfolio. The shares have trended steadily (if slowly) higher for the past couple of years, and the company pays a respectable dividend to shareholders. You're still long-term bullish on the stock and you'd like to keep it in your portfolio, but you're wary of an upcoming seasonal slump. It seems XYZ more or less trends sideways through the late-summer months, and you're looking for a way to turn that stagnant price action into profits.

With 200 shares of XYZ in your portfolio, you decide to take a modest approach by selling just one covered call option. That way, even if the stock defies history and rallies sharply, you won't risk your entire stake being called away.

With the shares trading just south of this round-number mark, you sell to open a 30-strike call, which is bid at 0.33. Since each contract is based on 100 shares of the underlying, you'll collect a credit of $33 for selling the option.

Potential Gains

Once you've sold your covered call option, the best-case scenario is for the stock to remain at or just below the strike price through expiration. This will allow your call to expire worthless, and the initial credit of $33 becomes your maximum profit on the option trade. Plus, since your shares were not called away, you still maintain exposure to any additional upside in the stock as an investor.

Breakeven on the option is equal to the strike price plus net credit -- or $30.33, in this case.

Potential Losses

If the stock tanks prior to expiration, you'll suffer losses as a shareholder -- but let's focus on the options end of the strategy.

In the event of a rally above the strike price, you could buy (to close) the call before the stock hits your breakeven rail. Given the relatively limited profit on a covered call, though, it often makes more sense to avoid another transaction, and simply deliver the shares at the strike price of the option. In this scenario, your primary "loss" is the upside potential you're sacrificing on the stock.

And what if XYZ does drop considerably? On the plus side, your call will almost definitely expire worthless -- and the premium you collected from the trade can partially offset any losses on the shares.

Volatility Impact

After you've sold your covered call option, the best-case scenario is for implied volatility to decline. This will lower the cost of your contract, making it cheaper to buy back in the future.

Other Considerations

If you've already collected a healthy profit on the stock, you might be ready to unload your shares and move on to the next investing opportunity. By selling calls at your desired exit price, you can essentially get paid to take profits on the stock.

Bear in mind that assignment is always a risk when selling a covered call. As such, be careful not to write calls against a stock you're not ready to part with. Or, as in the example above, you may write calls against only a portion of your shares, as opposed to the entire stake.

KEEP READING:
  • Short Call
  • Short Call Spread
  • Collar
0

0

0

Partnercenter


 

About Schaeffer's
Who We Are
More about Bernie
Business Hours
Schaeffer's Sitemap
How Can We Help?
Access Your Account
Contact Us
Privacy Policy
Legal Notices
Premium Products
Trading Services
Educational Programs
Deal of the Week
Free Market Newsletters
Let's get social:
Twitter logo Facebook logo Instagram logo YouTube logo Linkedin logo
© 2021 Schaeffer's Investment Research, Inc.
5151 Pfeiffer Road, Suite 450, Cincinnati, OH 45242
All Rights Reserved. Unauthorized reproduction of any SIR publication is strictly prohibited.