A covered call is a popular options trading
strategy where an investor, who is bullish on a particular stock or
asset, holds a long position on it, and at the same time, sells a
call option on that same stock or asset
in order to generate additional income. The call option sold is said
to be "covered" because the investor owns the underlying asset, which
can be delivered to the buyer of the call option if it is exercised.
By selling the call option, the investor receives a premium, which
provides some downside protection if the price of the underlying asset
falls. However, if the price of the asset rises above the strike price
of the call option, the investor may be required to sell the asset at
the agreed-upon price, missing out on any additional profits beyond
the strike price.
In a covered call strategy, the investor owns a certain number of shares of the underlying asset, which can be a stock, ETF, or other financial instrument. The investor then sells call options on those shares, typically with a strike price that is higher than the current market price of the asset. If the price of the asset stays below the strike price, the call option will expire worthless, and the investor keeps the premium received for selling the call option.
For example, let's say that an investor owns 100 shares of XYZ stock, which is currrently trading at $50 per share. The investor believes that the stock will stay relatively stable over the next few months, so they decide to sell a call option with a strike price of $55 for a premium of $2 per share. If the stock price stays below $55 until the option expires, the investor will keep the $200 premium and can sell another call option to generate more income.
However, if the stock price rises above $55, the investor may be required to sell their shares at that price. In this case, the investor would still make a profit, but it would be limited to the $55 strike price plus the $2 per share premium received for selling the call option. If the stock price continues to rise above $55, the investor would miss out on any additional profits beyond the strike price.
In summary, a covered call is a popular options trading strategy that can generate income for investors while providing some downside protection. However, it also limits the potential upside if the price of the underlying asset rises above the strike price of the call option.