One popular options trading strategy is the covered call strategy. In this strategy, a trader sells call options on an underlying asset they already own, in order to generate income and offset potential losses.

What is a Covered Call?

A covered call is an options strategy in which an investor holds a long position in an asset and sells call options on that same asset. The asset can be a stock, an exchange-traded fund (ETF), or even a commodity. The call options sold are covered because the trader already owns the underlying asset, and can deliver it if the options are exercised.

How Does this Strategy Work?

The covered call strategy involves two transactions: buying the underlying asset and selling call options on the same asset. Here’s how it works in practice:

• Buy the Underlying Asset: The trader purchases a specific amount of the underlying asset, such as 100 shares of a stock or an ETF.

• Sell Call Options: The trader then sells call options on the same underlying asset. The number of call options sold should be equal to the number of shares owned, and the strike price should be higher than the current market price of the underlying asset.

• Generate Income: The trader receives a premium for selling the call options. This premium generates income, which can help offset any losses in the underlying asset.

• Exercise or Expire: If the price of the underlying asset rises above the strike price of the call options, the options will be exercised, and the trader will sell the underlying asset at the higher strike price. If the price of the underlying asset does not rise above the strike price, the options will expire worthless, and the trader will keep the premium.

Advantages of the Covered Call Strategy

What are the main advantages of this kind of trading strategy?

• Generates Income: The covered call strategy generates income for the trader, which can help offset potential losses in the underlying asset.

• Reduces Risk: By selling call options, the trader reduces their risk because they receive a premium for selling the options. This premium can help offset any losses in the underlying asset.

• Increases Probability of Profit: The covered call strategy increases the probability of profit because the trader receives a premium for selling the call options, which they keep if the options expire worthless.

• Provides Upside Potential: While the covered call strategy limits the upside potential of the underlying asset, the trader can still profit from an increase in the asset’s price up to the strike price of the call options.

Main disadvantages in using this technique

Of course, this trading strategy also has some critical issues that one should keep in mind before using it. Below we look at the main drawbacks to using this technique.

• Limits Upside Potential: The covered call strategy limits the upside potential of the underlying asset. If the price of the asset rises significantly above the strike price of the call options, the trader will sell the asset at the lower strike price and miss out on potential profits.

• Increases Downside Risk: While the covered call strategy reduces risk, it also increases downside risk. If the price of the underlying asset falls significantly, the premium received for selling the call options may not be enough to offset the losses in the asset.

• Potential for Early Exercise: There is a risk that the call options may be exercised early, which would require the trader to sell the underlying asset at the strike price, regardless of its current market value.

• Limited Use in Bearish Markets: The covered call strategy is most effective in neutral or slightly bullish markets. In bearish markets, the strategy may not be effective in generating income or reducing risk.

Trading using the covered call strategy: a practical example

Let’s say a trader owns 100 shares of XYZ stock, which is currently trading at $50 per share.

The trader believes that the stock is unlikely to rise significantly above its current price but is also hesitant to sell the stock outright. Instead, the trader decides to use the covered call strategy to generate additional income.

The trader sells one call option contract with a strike price of $55 and an expiration date three months in the future. The premium for selling the call option is $3 per share, or $300 for the entire contract.

If the price of XYZ stock remains below the $55 strike price, the call option will expire worthless, and the trader will keep the premium of $300. The trader can then sell another call option to generate additional income.

If the price of XYZ stock rises above the $55 strike price, the call option will be exercised, and the trader will be required to sell the 100 shares of XYZ stock at $55 per share. This means the trader will miss out on potential profits if the stock rises above $55.

However, the trader still earns the premium of $3 per share, which reduces the overall loss on the stock. If the stock price rises above the strike price, the trader can always buy back the call option at a higher price to avoid selling the stock.

Overall, the covered call strategy can be a useful tool for traders who want to generate income from an underlying asset while minimizing their risk. However, as with any options strategy, it’s important to understand the potential risks and rewards before investing your money.