A covered call is a type of options strategy in which a trader sells a call option on a stock that they own. The goal of a covered call is to generate income from the premium received for selling the call option, while limiting the downside risk if the stock price falls.
When a trader sells a call option, they agree to sell the stock at a certain price (the strike price) on a certain date (the expiration date). If the stock price is below the strike price at expiration, the option will expire worthless and the trader will keep the premium they received for selling the option. However, if the stock price is above the strike price at expiration, the option will be exercised and the trader will be forced to sell the stock at the strike price.
The maximum profit from a covered call is the premium received for selling the option. The maximum loss is the difference between the strike price and the stock price at expiration.
Covered calls are a relatively low-risk strategy that can generate income for investors. However, they do not offer the same potential for unlimited gains as other options strategies, such as naked calls.
Benefits of covered calls
Covered calls offer a number of benefits to investors, including:
- Income generation: Covered calls generate income in the form of the premium received for selling the call option.
- Limited downside risk: The maximum loss on a covered call is limited to the premium received for selling the call option.
- Capital preservation: Covered calls can help to preserve capital by limiting the downside risk if the stock price falls.
- Tax efficiency: Covered calls can be tax-efficient, as the premium received for selling the call option is taxed at the same rate as ordinary income.
However, covered calls also have some risks, which investors should be aware of before entering into this strategy. These risks include:
- Stock price appreciation: If the stock price rises above the strike price of the call option, the investor will lose the difference between the strike price and the stock price.
- Early exercise: The option holder may exercise the call option early, which could force the investor to sell the stock at a lower price than they would have liked.
- Time decay: The value of the call option will decrease over time, which will reduce the amount of income generated from the strategy.
Investors should carefully consider the benefits and risks of covered calls before entering into this strategy.
Risks of covered calls
There are a number of risks associated with covered calls, including:
The stock price could rise above the strike price of the call option. If this happens, the call option will be exercised and the investor will be forced to sell their shares at the strike price. This could result in a loss if the stock price continues to rise after the option is exercised.
The stock price could fall below the strike price of the call option. If this happens, the investor will lose the premium they received for selling the call option. However, they will also keep their shares of stock, which could potentially rebound in value.
The implied volatility of the stock’s options could decrease. If this happens, the premium that can be collected for selling a call option will decrease. This could reduce the overall profitability of the covered call strategy.
The investor could experience a margin call if the stock price falls below the maintenance margin. This is a requirement that investors must maintain a certain amount of equity in their account to cover the potential losses on their positions. If the investor’s equity falls below the maintenance margin, they will be required to deposit additional funds into their account or sell some of their positions.
By understanding the risks associated with covered calls, investors can make informed decisions about whether or not this strategy is right for them.
How to choose the best covered call stocks
To find the best stocks for covered calls, investors should look for stocks that have a high dividend yield, a low beta, and a strong track record of price appreciation. They should also consider the implied volatility of the stock’s options, as this will affect the premium that can be collected for selling a call option.
Here are some of the factors that investors should consider when choosing stocks for covered calls:
- Dividend yield: The dividend yield is the annual dividend paid by a stock divided by its current price. A high dividend yield can help to offset the potential losses from a covered call if the stock price falls.
- Beta: Beta is a measure of a stock’s volatility relative to the market as a whole. A low beta stock is less volatile than the market, which can help to reduce the risk of a covered call.
- Price appreciation: Stocks with a strong track record of price appreciation are more likely to generate a high premium for a covered call.
- Implied volatility: The implied volatility of a stock’s options is a measure of the market’s expectation of future volatility. A high implied volatility will result in a higher premium for a covered call.
By considering these factors, investors can find the best stocks for covered calls and generate income while limiting their downside risk.
How to place a covered call trade
To place a covered call trade, you will need to:
1. Select a stock that you are bullish on and that has a high dividend yield.
2. Buy 100 shares of the stock.
3. Sell 1 call option on the stock.
4. The strike price of the call option should be above the current stock price.
5. The expiration date of the call option should be at least 3 months away.
The premium that you receive for selling the call option will be your potential profit. However, if the stock price rises above the strike price of the call option, you will be obligated to sell the stock at that price. This is the maximum loss that you can incur on the trade.
Here is an example of a covered call trade:
Stock: XYZ Corporation
Current stock price: $50
Strike price of the call option: $55
Expiration date of the call option: 3 months
Premium received for selling the call option: $2
In this example, the maximum profit that you can make on the trade is $2. If the stock price rises above $55, you will be obligated to sell the stock at that price. However, you will still keep the $2 premium that you received for selling the call option.
The maximum loss that you can incur on the trade is $5. If the stock price falls below $50, you will lose the $50 that you invested in the stock. You will also lose the $2 premium that you received for selling the call option.
Covered call trades can be a good way to generate income from your investments while limiting your downside risk. However, it is important to understand the risks involved before you enter into a covered call trade.
Tax implications of covered calls
When you sell a covered call, you will realize a taxable gain or loss on the difference between the strike price of the call option and the price you paid for the stock. If the call option expires worthless, you will realize a capital gain on the difference between the strike price and the stock’s purchase price. If the call option is exercised, you will realize a capital gain or loss on the difference between the stock’s sale price and your purchase price.
In addition, you will also owe taxes on the premium you receive for selling the call option. This premium is considered ordinary income and is taxed at your regular income tax rate.
It is important to consult with a tax advisor to understand the specific tax implications of covered calls in your situation.
