What is a Covered Call

Lately I have been looking at options a bit more. Options trading is new to me so I have been studying it a little. I am trading comes covered calls.

A covered call is a transaction in which the seller of call options already owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. These owned shares provide the “cover” as they can be handed over to the buyer of the options when he decides to exercise them, instead of having to buy the optioned shares at unfavorable market prices in the case of “uncovered” or short call. Thus, the covered call limits the (potentially unlimited) loss that results from a short call when the price of the underlying stock moves above the strike price of the option.

For example, let’s say that you own shares of the XZY Aluminum and like its long-term prospects as well as its share price but feel in the shorter term the stock will likely trade relatively flat, perhaps within a few dollars of its current price of, say, $11. If you sell a call option on XZY for $12, you earn the premium from the option sale but cap your upside. One of three scenarios is going to play out:

a) XZY shares trade flat (below the $12 strike price) – the option will expire worthless and you keep the premium from the option. In this case, by using the buy-write strategy you have successfully outperformed the stock.

b) XZY shares fall – the option expires worthless, you keep the premium, and again you outperform the stock.

c) XZY shares rise above $12 – the option is exercised, and your upside is capped at $12, plus the option premium. In this case, if the stock price goes higher than $12, plus the premium, your buy-write strategy has underperformed the XZY shares.

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