Covered Call

The Setup

Suppose you own 100 shares of a company called TechGrowth, which is currently trading at $100 per share. You decide to sell a call option with a strike price of $110 that expires in one month, receiving a premium of $5 per option.

Who Should Consider It

The covered call strategy is suitable for investors with a neutral to slightly bullish outlook on the underlying stock. It's ideal for those looking to earn passive income from their stock holdings, especially if they believe the stock price will not increase significantly in the near term.

Strategy Explained

By selling a call option, you are agreeing to sell your shares at the strike price if the option buyer decides to exercise the option. This happens if the stock's price goes above the strike price at or before expiration. If the stock's price stays below the strike price, the option expires worthless, and you keep the premium as your profit, in addition to retaining your stock.

Breakeven Process

The breakeven point for a covered call strategy is calculated by subtracting the premium received from your original cost basis in the stock. For instance, if your cost basis was $95 per share, and you received $5 per share in option premiums, your adjusted cost basis becomes $90 per share.

Sweet Spot

The sweet spot for this strategy is when the stock price is right at or slightly below the strike price at expiration. This allows you to keep the premium and your shares, maximizing income while maintaining your stock position.

Max Profit Potential

The maximum profit is limited to the premium received plus the gain on the shares if they are called away. In the TechGrowth example, if the stock ends up at $110, you gain $10 per share on the stock ($110 - $100) plus the $5 premium, totaling $15 per share.

Max Loss

The maximum loss occurs if the stock price goes to zero. In such a case, you would lose your entire investment in the stock, minus the premium received. Therefore, while the premium provides some downside protection, it does not eliminate the risk of holding the stock.

Risk

The risk is primarily that of holding the stock itself. The covered call strategy does not provide significant protection against a decline in stock price. However, the premium received does offer a slight cushion against losses.

Time Decay

Time decay works in your favor in a covered call strategy. As the expiration date approaches, the value of the option you sold will decrease, provided the stock price does not exceed the strike price, increasing the likelihood that you will retain the full premium.

Implied Volatility

Higher implied volatility increases the premium you can receive from selling the call option, which enhances the potential return from the strategy. Conversely, if volatility decreases after you have sold the call, it benefits you because the likelihood of the option being exercised decreases.

Conclusion

The covered call strategy is a conservative way to generate income on your stock holdings and can offer slight downside protection. It is particularly appealing to investors who are looking for income and are willing to cap their upside potential on the stocks they own. It requires careful consideration of strike price and expiration to balance between earning potential and risk of losing stock at too low a price.