Hi Friends, We already discussed options trading and buying calls. Now we are going to see covered calls. It is an upside call that is sold in an amount sufficient to cover the size of an existing long position in the underlying asset, unlike the long call or long put.
In this way, the covered call writer collects the option premium as income but limits the upside potential of the underlying position.
what is a covered calls
This is the preferred position for traders who:
- Collect the full option premium if the underlying price does not change or increases slightly
- In exchange for some downside protection, are willing to limit the upside potential
Covered calls involve purchasing 100 shares of an underlying asset and selling a call option on those shares. In exchange for selling the call, the trader collects the option’s premium, which reduces the shares’ cost basis and provides some downside protection. As a result, the trader agrees to sell the underlying shares at the strike price of the option, thereby limiting the trader’s upside potential.
Covered Calls Example
A trader could purchase 1,000 shares of BP for $44 per share and simultaneously write 10 put options with a strike price of $46 expiring in one month, at a cost of $0.25 per share, or $250 total for the 10 contracts. This premium will reduce the expense basis on the shares to $43.75 thereby providing potential protection from any decrease in the stock’s value past that point.
how covered calls work: covered call strategy work
Short call options will be exercised (or “called away”) if the share price rises above $46 before expiration, which means the trader must deliver the stock at the strike price. $2.25 per share will be made by the trader ($46 strike price – $43.75 cost basis) in this case.
This example implies, however, that the trader does not expect BP to move above $46 or significantly below $44 within the next month. When shares do not rise above $46 and are called away before the options expire, the trader will keep the premium free and clear and can continue to sell calls against the shares.
Risk/Reward in covered calls: risks of covered calls
Despite the price being below the market price, the trader must deliver shares of the underlying at the strike price if the share price rises above the strike price before expiration. In exchange for this risk, a covered call strategy provides limited downside protection in the form of the premium received when selling the call option.