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Covered Calls


If you are an investor, you will have to make some critical decisions at some point as a result of market and price fluctuations. You might have to sell your stock for huge immediate gains and still expect the long-term appreciation benefits. This is what the covered calls allow you to do.

This popular options strategy acts as a hedge on a long-term investment, allowing you to buy-write your options and earn a premium. This article will tell you more about covered calls; their meaning, the risks involved, and other relevant details that will aid you to make a sound decision.

What is a Covered Call?

A covered call is an options strategy that investors use to earn income in the form of options premiums. To execute a covered call, an investor who holds a long position in an asset writes (sells) call options on that asset.

Most times, a covered call is employed by those investors who plan to hold a stock for a long time but are not sure if the price will appreciate significantly in the nearest future. Covered calls act as a short-term hedge for long-term position stocks so that investors can gain through the premium received from writing options.

The consequence though is that the investor will have to forfeit stock gains if the price rises above the option's strike price. Also, they must give 100 shares (for each contract written), If the buyer decides to exercise the option.

Covered Call Example:

An investor owns 100 shares in company XYZ. Both the price of the shares and their long-term prospect are attractive, but the investor feels the value of the stock will fall short, by $50 of the current price.

The investor may decide to sell a call option on XYZ with a strike price of $52 and earn the premium, but for the duration of the option, cap their upside on the stock to $52. Assume the premium they receive for writing a four-month call option is $0.65 per share, that is $65

Now there are two sides to this. If XYZ shares perform less than the $52 strike price, at the expiration of the option, the investor will keep the premium from the option. This means that by using this strategy they were able to outperform the stock. While they still own the stock, they have an extra $65.

On the flip side, if XYZ shares rise above $52, the option is exercised, and the upside in the stock is capped at $52. If the price goes above $52, let's say $52.50 (strike price plus premium), the investor would have made more if he(she) held the stock. Although, they are not at a total loss.

In summary, a covered call occurs when an investor intends to hold a stock for a long time but does not expect an appreciable price increase in the near term. He(she) now decides to generate income (premiums) while waiting for the long-term gain.

How Risky is a Covered Call?

How risky is a Covered Call.

There are two types of risk associated with using the covered call strategy:

The Risk of Losing Money

This is the first and real risk, it applies when the stock price falls below the breakeven point. (The purchase price of the stock minus the option premium received)

As with any stock strategy, there is a significant risk. Although stock prices can only fall to zero, this is still 100% of the amount invested, so covered call investors must be a stock market risk.

The Opportunity Risk of Not Participating in a Large Stock Price Rise

As long as the covered call is open, the covered call writer is obligated to sell the stock at the strike price. Although the premium provides some profit potential above the strike price, that profit potential is limited.

Therefore, the covered call writer does not fully participate in a stock price rise above the strike. In the event of a substantial stock price rise, covered call writers often feel that they “missed a great opportunity".

Nonetheless, if you understand the details of the investment, it can go a long way to mitigate the potential risks. Also, it is recommended that you work with an investment specialist, it can be of great help for risk management in investment.

But in all, an informed decision is a key to successful investment.

What Delta Should I Use for Covered Calls?

The Delta is a vital consideration when it comes to investing in covered calls. This is because they try to avoid in-the-money expiration at all costs. Such a situation will require them to buy the option again or deliver the underlying stock

Delta measures how much the price of an option is expected to change with every $1.00 change in the price of the underlying stock. For example, a Delta of 0.20 means that the price of the option will theoretically move to $0.20 per $1.00 move in the price of the underlying stock.

If you intend to invest in covered calls, Delta tells you the tendency that the option will expire in the money. A delta of 0.50 means that the option has a 50% chance of being in the money at expiration.

The call closest to 40 deltas is the most recommended. For instance, if you have a strike with a delta of .38 and .43 you should go for the .38.

Is it a Bullish or a Bearish Strategy?

A bullish investor is also known as "a bull". A bull believes and looks forward to a rise in the price of a security or more. Sometimes it is with the market, a bullish investor believes that the market will go up and already anticipate the profit they will make.

At other times, the bullish investor might foresee gains in stock, bond, collectible, commodity, or even a specific industry. The point is when an investor anticipates a price rise, whether in a stock or currency, you can address the investor as being bullish. The sentiment that drives bullish investors can be said to be greed or fear of missing out.

Are Covered Calls Bullish.

A bull market exists when prices of equities are generally rising. Though not every stock will experience this rise, the market’s main equity indexes increase. Unlike a bear market, there is no universally accepted percentage gauge for how much a market has to rise before it qualifies as a bull market.

Fun Fact The longest bull market in the history of stocks in America is from December 1987 to March 2000 and lasted for 4,494 days.

A bearish investor is also known as "a bear". In contrast to the bullish investor, this investor believes that prices will go down. The bearish investor, just like the bullish investor can foresee a fall in the price of the stocks, the market as a whole, or specific industries.

Any investor who foresees a market-wide dip in commodities, stocks, bonds, currencies or collectibles, is said to be bearish because he (she) anticipates a significant downturn. The prevailing sentiment for bearish investors might be the fear that a coming downturn will affect their wealth negatively.

A bear market is a market in which the prices of securities in a key market index have recorded a fall over a recent period by at least 20%. This kind of fall isn’t the normal short-term dip you see during a correction, a period when there are declines in prices of 10% to 20%.

A bear market leaves investors feeling pessimistic about the future of the financial market or some part of a financial market. The longest bear market in US history was from March 10, 1937, to April 28, 1942, and it lasted for 61 months. The most severe of them ran from Sept. 3, 1929, to July 8, 1932, and the market value fell by 86%.

These two terms are practically a reflection of how investor's sentiments and moods affect transactions. In comparison, a bullish investor foresees the price rise and decides to hold, while the bearish investor anticipates a fall and decides to sell the option.

A covered call might not be the best option for the extremely bullish nor the extremely bearish investors. For a very bullish investor, they might just want to hold the stock rather than write an option. If the stock prices spikes, the option can capitalize the profit on the stock and result in a reduction in the overall profit of the trade.

Are Covered Calls Bearish.

On the other hand, the very bearish investor may prefer to sell the stock, since the premium received may make up for any losses that may result.

Covered calls are just a safe way to invest in bonds and other commodities - a neutral strategy. The investor does not expect much increase or much decrease in the underlying stock price throughout the written call option. Investors employ this strategy to hold stocks and make gains both for short-term and long-term purposes.

A covered call acts as a short-term hedge on a long stock position and allows investors to earn an income premium from the writing option. Though, the investor is required to forfeit the stock gains if the price moves above the option's strike price. Also, they'll have to give up100 shares (for each contract written) if the buyer decides to exercise the option.

Are There Similar Trading Strategies?

Many other option strategies help minimize risks and increase potentials for better income earnings, they are:

How Can You Be Successful with Selling Covered Calls?

Selling covered calls offer investors a lot of benefits such as:

Generating Income through Premium

This is one of the major benefits of the covered calls option. Many investors use covered calls to get premiums temporarily while waiting for long-term returns. Some investors even sell covered calls regularly; monthly, quarterly, etc.

Risk Reduction

Sometimes, the premium received per share reduces the break-even point of owning this stock and, therefore, reduces risk. However, the premium received from selling a covered call is only a small fraction of the stock price.

Helps Investors Set a Target

Selling covered calls can help investors target a selling price for the stock that is above the current price.

Conclusion

When it comes to options strategy, covered calls are one of the most popular. Aside from its popularity, it also has a high potential for generating income, both on a long and short-term basis. However, you need to study the option thoroughly, as well as understand market movements to make real success.