A Covered Call Strategy is used by investors who own shares and expect limited near-term growth. By selling a call option on the stock they own, investors earn a premium while holding the stock. The strategy is ideal for those with a neutral to moderately bullish outlook on the stock.
How It Works
- The investor sells an out-of-the-money (OTM) call option while owning the underlying stock.
- If the stock price remains below the strike price, the call option expires worthless, and the investor keeps the premium.
- If the stock rises above the strike price, the call is exercised, and the investor must sell the stock at the strike price, earning both the premium and the target exit price.
Example
An investor owns a stock and sells an OTM call at a desired exit price. If the stock stays below the strike price, the call is not exercised, and the investor retains the premium as extra income. If the stock rises beyond the strike price, the investor sells at the agreed strike price, earning both the premium and stock sale proceeds.
Benefits
- Generates additional income from the call premium.
- Provides downside cushion, as the premium offsets small losses.
- Works well in neutral to slightly bullish markets.
Risks & Limitations
- Limited upside – Gains are capped at the strike price plus the premium.
- Potential loss if stock declines significantly, but the premium provides some buffer.
Key Metrics
- Max Risk = Stock Price Paid – Premium Received
- Reward (Max Profit) = (Strike Price – Stock Price Paid) + Premium
- Breakeven = Stock Price Paid – Premium
Considerations for Traders
A Covered Call Strategy works best for investors who do not expect large price movements in the stock. However, it’s important to time the trade carefully—selling calls when implied volatility is high can result in a higher premium. Additionally, traders should monitor the stock price movement and be prepared to adjust their strategy if market conditions change, such as rolling the call to a higher strike price or closing the position early to lock in profits.
Conclusion
The Covered Call Strategy is a great way to earn passive income from stocks, especially in sideways or moderately bullish markets. While it limits upside potential, it offers consistent returns and reduces short-term risks.