Covering a position is a commonly used trading strategy. In a covered call, an already open position owner sells call options to generate extra income from that same stock or security. The covered call is more profitable than other option strategies because it brings in steady income for the investor and does not involve additional risk factors(check out saxo broker for all the help you need in covered calls).
In this article, we will describe what have covered calls and how to use them in trading so you too can start earning some extra money from your current positions.
Covered Calls: What Are They?
A covered call is a conservative strategy where a stock owner writes a specific number of near-term put options at a strike price a few percentage points below their purchase price. In return for writing the call, the stock owner gets a premium from the buyer of the options contract, who has the right to sell their shares at that same strike price any time before expiration.
Every option contract covers 100 shares of a specific security, so when an investor uses this strategy, they must have enough funds to purchase 100 shares for each put option written. The idea behind a covered call is that if a stock’s price doesn’t rise above the strike price by expiration, both options will expire worthlessly. The original stock owner can keep their position without needing to cover or buy more shares.
If prices go up past the strike price, then only one part of this strategy is affected: The buyer of the options will exercise their option to sell 100 shares at the strike price, and the stock owner is obliged to deliver those shares.
Covered Calls: How Can They Help Me?
Now you know what covered calls are and how they work, but does this strategy help investors or is it another one of those pointless trading terms? For starters, there are several ways covered calls can provide extra income for traders:
Generate regular income from your existing positions
This strategy lets you generate extra income from a position by selling call options against it. It’s a good strategy for investors who want to generate extra income and don’t care about limiting their potential upside (because if the stock’s price rises above the strike, only one part of this strategy is affected: The buyer of your written call will exercise their option to sell 100 shares at the strike price, and you are obliged to deliver those shares. You should purchase that many shares before offering them up for sale).
Offsetting declining positions
If you already own a position that is dropping in value, then writing covered calls provides extra income while helping limit your loss exposure by selling off part of your position. You get out what you put in and limit any further downside because the premium received from the written call should offset some or all of your initial loss.
Covering deep-in-the-money positions
If you already own a position that is deep in the money, then writing covered calls provides extra income from your long stock holdings. By selling an option against it, you increase the margin requirement, which may force you to remove part of your excess holdings from this trade, so if a significant price move doesn’t occur before expiration, you can keep this extra income without having to buy more shares.
However, there are also several important factors and risks associated with this strategy – things traders need to be aware of before implementing:
You have limited upside potential until the options contract expires – as with any covered call writing strategy, your ability to profit from a covered call is limited to the premium you receive for selling the written option.
If the stock rises above the strike price by expiration, then only one part of this strategy is affected: The buyer of your written call will exercise their option to sell 100 shares at the strike price, and you are obliged to deliver those shares. You should purchase that many shares before offering them up for sale).