Thursday, 01 December, 2022

What are covered calls and how to use them in trading?


Covered calls are options strategy that involves both stock and options trading. The investor first buys or already owns the underlying stock and then sells call options on that stock to generate income.

The covered call is one of the most basic options strategies. It is suitable for bullish investors on the underlying security who wish to generate income from their position. It is also a relatively low-risk strategy, as the downside of the underlying stock protects the investor.

How to use a covered call strategy?

Traders can use the covered call strategy in several different ways to meet an investor’s goals, and it can be used as a standalone strategy or as part of a more comprehensive investment plan. It can also generate income, protect downside risk, or even speculate on future price movements. No matter how it is used, covered calls offer investors a versatile tool that can be employed in various market conditions.

To enter a covered call position, the investor first buys or already owns the underlying stock. He then sells call options on that stock, with the strike price set at or above the stock’s current market price. The number of contracts sold should equal the number of shares owned.

The investor will then receive premium income from the call options sold, which can offset some of the stock’s downside risks. If the stock price rises, the investor will still profit from the stock’s upside, minus the premium received from selling the calls.

If the stock price decreases or remains unchanged, the investor will still have downside protection as long as the strike price of the call options sold is above the stock’s current market price. The breakeven point for this strategy is reached when the stock price equals the strike price plus the premium received.

Risks associated with covered calls

Covered calls are a relatively simple and popular options strategy, but a few risks to consider. First, if the stock price increases sharply after selling the call options, the investor may miss out on additional profits that could have been made by holding on to the stock.

Second, if the stock price decreases sharply after selling the call options, the investor may be forced to sell the stock at a loss to cover the margin requirements for holding the short call position.

Lastly, suppose the stock goes into bankruptcy before the expiration of the call options sold. In that case, the investor may not receive any payment for their call options and may even be required to deliver shares of the stock to fulfil their obligations under the options contract.

Advantages of covered calls

Cover calls can be a helpful tool for bullish investors on a particular stock who wish to generate income from their position despite these risks. When used correctly, covered calls can help hedge downside risk and provide a potential source of additional income.

Covered calls can also be used as part of a more comprehensive options trading strategy. For example, an investor who is bullish on a stock but wishes to limit their downside risk may sell covered calls while simultaneously buying put options.

This strategy, known as a straddle, can help hedge the investor’s position and provide a potential profit if the stock price increases or decreases sharply.

When entering a covered call position, the investor should consider the following factors:

  • The strike price of the call options sold
  • The expiration date of the call options
  • The premium received for selling the call options
  • The current market price of the underlying stock
  • The level of protection desired against a decrease in the stock price

Conclusion

By taking these factors into account, the investor can help to ensure that the covered call strategy is well-suited to their investment goals and risk tolerance. Novice traders are advised to contact an online broker from Saxo Bank before using covered calls; get more info here.