A covered call is a stock option strategy that an investor uses when they want to hold a long position and sells call options on the very same asset that they are holding. This is done in an effort to increase the income produced from that asset. This usually occurs when the investor has a short term view on the asset, yet they are in a long position. In a way, this makes it possible for a person in a long position to be in a short position too and still be able to generate income from the investment.
An example of how a covered call works is this: If you own shares of XYZ Zippers and you like its long-term prospects as well as the price of their shares but you feel that the stock will trade flat in the shorter term, maybe within a few dollars of the current price of $25, you can sell a call option on XYZ for $26. You are capping your upside while you are earning the premium. From here, one of three events are going to happen.
One of the scenarios that may play out when you cover call your option is that the XYZ share trades flat, which means it trades below its strike price of $26. If the option expires, you do get to keep your premium. If this happens, you have managed to beat the stock. This is an important idea to understand when it comes to stock option basics.
The second scenario is that the shares of XYZ fall. Your option expires and it is completely worthless. You still get to keep your premium and, once again, you have beaten the stock.
The third scenario is that your shares of XYZ rise above $26. When this happens, you are capped at $26. Being capped at $26 you have lost against the stock. So if the shares rose to $27, you lost $1 per sale, so your covered call didn't work very well for you.
You want to use covered calls in hopes that the shares stay flat or they fall because you are going to be locked in at that $26 price.
The term "Buy-Write is a term that is used to describe the selling of your options at the price that you set. In the above scenario regarding XYZ, you exercised a Buy-Write.
The purpose of covered calls is to make sure you cover the risk regarding your investment. If the shares were $15 and you set a strike price of $16 and the shares drop to $13, you are still covered at $16. You are minimizing the amount of risk and making yourself profitable in case the shares do not change in price or in case they fall in price. And if nothing happens after you set the strike price and the option is allowed to expire, you're okay. You are in a good position rather than in a bad position. Don't let the term "expiration" scare you because it does not mean anything bad. It just means that taking action on the option is no longer allowable. Action must be taken by that expiration date.
So if you are interested in investing in stock options and you are more interested in the short term than the long term in order to benefit from your investment, stock option covered calls can help you do this. If you are ever confused or want help in initiating strategies, or you just want to get started in options investing, a financial advisor can help you become a success and to make the most of your money. You can set up a strong financial future this way.
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