The covered call strategy is not a hedged play in the most traditional sense of the word. Instead, it's more accurately described as a way of generating income on a stock investment that might not be living up to your short-term expectations. In this scenario, in fact, the "hedge" is the asset you already own -- namely, shares of any given optionable stock.
In this strategy, a shareholder sells (or writes) a call option against one of his or her stock investments. To ensure all of the calls are "covered," as opposed to "naked," no more than one call option is sold per 100 shares of stock.
The sale of the covered call(s) immediately generates a premium payment for the seller -- which is the maximum reward on the options trade, should the calls expire worthless. And even if those calls move into the money by expiration, the trader already has sufficient stock on hand to meet any assignment obligations.
To examine how the covered call works, let's check out an example.
Stock XYZ has been a solid addition to your portfolio. The shares have trended steadily (if slowly) higher for the past couple of years, and the company pays a respectable dividend to shareholders. You're still long-term bullish on the stock and you'd like to keep it in your portfolio, but you're wary of an upcoming seasonal slump. It seems XYZ more or less trends sideways through the late-summer months, and you're looking for a way to turn that stagnant price action into profits.
With 200 shares of XYZ in your portfolio, you decide to take a modest approach by selling just one covered call option. That way, even if the stock defies history and rallies sharply, you won't risk your entire stake being called away.
With the shares trading just south of this round-number mark, you sell to open a 30-strike call, which is bid at 0.33. Since each contract is based on 100 shares of the underlying, you'll collect a credit of $33 for selling the option.
Once you've sold your covered call option, the best-case scenario is for the stock to remain at or just below the strike price through expiration. This will allow your call to expire worthless, and the initial credit of $33 becomes your maximum profit on the option trade. Plus, since your shares were not called away, you still maintain exposure to any additional upside in the stock as an investor.
Breakeven on the option is equal to the strike price plus net credit -- or $30.33, in this case.
If the stock tanks prior to expiration, you'll suffer losses as a shareholder -- but let's focus on the options end of the strategy.
In the event of a rally above the strike price, you could buy (to close) the call before the stock hits your breakeven rail. Given the relatively limited profit on a covered call, though, it often makes more sense to avoid another transaction, and simply deliver the shares at the strike price of the option. In this scenario, your primary "loss" is the upside potential you're sacrificing on the stock.
And what if XYZ does drop considerably? On the plus side, your call will almost definitely expire worthless -- and the premium you collected from the trade can partially offset any losses on the shares.
After you've sold your covered call option, the best-case scenario is for implied volatility to decline. This will lower the cost of your contract, making it cheaper to buy back in the future.
If you've already collected a healthy profit on the stock, you might be ready to unload your shares and move on to the next investing opportunity. By selling calls at your desired exit price, you can essentially get paid to take profits on the stock.
Bear in mind that assignment is always a risk when selling a covered call. As such, be careful not to write calls against a stock you're not ready to part with. Or, as in the example above, you may write calls against only a portion of your shares, as opposed to the entire stake.
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