Covered call is an investment term which income investors refer to quite often. Investopedia defines a covered call as “an options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset.” To backtrack a little, a call provides an investor the right, but not the obligation to purchase an investment at a predetermined price within a specific time period. Thus, the call buyer’s maximum loss is the premium he paid. In the case of a covered call, however, the investor sells that right for a premium, (immediate cash in her account). While the positive result of selling a call is cash in one’s account; the consequence of receiving the cash is the obligation to deliver a specified number of shares at a specified price. A call buyer would “call” any stock which is worth more than the strike price before expiration—that is the agreed price of the call. For instance, if he buys a call of XYZ at 55 and it is trading for 60, he can then require the stock to be delivered to him. He then has made a five-dollar profit. When one sells a call, he is obligated to deliver the stock to the buyer of the call within a defined time period. Selling calls “naked,” that is selling without owning the underlying stock, is a highly dangerous activity because the seller’s loss is unlimited. The seller’s loss is unlimited because in theory the value of the stock could go to infinity. Therefore, selling a covered call means the individual would be obligated to turn his stock over to the buyer if it was called. Since, he already owns the stock; he is considered “covered”.
Investment guru Rida Morwa claims that investors must understand the “trade-off” between losing the upside potential of a stock for consistent income. “There is no free lunch,” claims Morwa. “A covered call…is clearly better suited, for those investors who seek income but with less price volatility, at the expense of sacrificing some upside potential during a strong bull market.” Without question this is a key point of covered call writing, the seller of the call caps her investment gain and sacrifices any windfall above and beyond the strike price. Therefore, covered call writing is only suited for income investors who are less concerned with growth.
For more information on covered call writing, option trading and investing in general, contact Innovative Investment Solutions, Inc.
IMPORTANT CONTENT DISCLAIMER
The information presented and made available in this article is intended for educational purposes only. The information is not and should not be confused with investment advice and does not attempt or claim to be a complete description of any specific securities or markets. This information is of a general nature and has not been prepared with regard to any particular person’s investment objectives, financial situation and/or particular needs.
The opinions and analyses included herein are based on sources and data believed to be reliable and are presented in good faith; however, no representation or warranty, expressed or implied is made as to their completeness or accuracy. It is imperative to understand your investment risks since all stock and option investments involve significant risk. The risk of loss in trading securities and options can be substantial.