Covered Calls Explained

Covered Calls Explained includes how, when and why we like to use the Covered Call strategy through shorting Call Options.

To use the Covered Call Strategy, one must buy the underlying security, and short a equivalent amount of, Out of The Money (OTM) Call Options to “cover” the position. For example, one would buy 100 shares in company XYZ, and short 1 call option with a higher strike price than the underlying securities price. Since 1 option is the equivalent of 100 shares, that covers oneself from upside losses.

We like to use Covered Call strategy after companies have announced a dividend, and when the option’s expiry date is after the ex dividend date. This is because dividend payouts reduce a stock’s price, making it more likely that the stock’s price won’t reach the call option’s strike price, resulting in the option/s to expire worthless, and those who short calls to receive the option’s premium.

We also like to use the Covered Call Strategy, when the underlying securities’ price isn’t volatile in nature. Since time decay will take affect, and as long as the underlying securities’ price doesn’t reach the call option’s strike price, once again call writers receive the option’s premium.

Lastly even though Covered Calls are seen as being low risk, Covered Call Strategy restricts upside profit potential, if the underlying securities’ price continues to appreciate. The second disadvantage, is if the underlying security price drops substantially, the premium received, won’t be enough to cover the underlying securities’ position depreciation.

To make readers think about risks and reward outlined in Covered Call Options Strategy.
riskvs reward by Nick Youngson.
Licensed under a CC BY-SA 3.0 licence.

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