Investing Basics: Covered Calls

A covered call as
an option strategy that can help investors
earn additional income on securities like stocks
or ETFs they already own. Many investors
sell covered calls, because they have lower risk
than other options strategies. A covered call strategy involves
an investor owning or buying shares of stock and
selling call options, often at a strike above
the stock’s current price, in order to collect a premium. If the stock’s price rises above
the strike price of the sold option, and the
option is exercised, the covered call
writer is obligated to sell the stock
at the strike price. If the stock price does not rise
up to the call’s strike price or declined by more than
the premium received, the trade can make money. For example, suppose
there’s an investor who owns 100 shares of
stock at $100 per share. After analyzing the stock’s
price movement and trend, the investor doesn’t think
the stock price will rise much in the next few months. So he decides to sell a
call option with a strike price of $105 on his stock. For selling this
option, he earns $300. Now, depending on what the
stock does, one of two things will happen. As long as the stock price
doesn’t rise above $105, the option will expire, and
the investor keeps his stock. However, if the
price goes down, he could lose money on his
stock, but any losses could be partially offset
by the option premium, less any commissions and fees. But if the stock does
move higher than $105, the option would
likely be exercised, and the investor would be
forced to sell his shares. However, he still profited from
the shares increasing in price, plus the option premium,
less commissions and fees. But keep in mind,
there is a risk of missing out on further
gains if the stock goes up any further. There is also the risk of
the stock’s price going down, but that can happen any
time you own a stock. A covered call doesn’t just
bring in income on stock you own. Some investors buy stock
and sell a covered call at the same time. This is called a
buy-write, and it can help lower the
[? effective ?] cost of purchasing the new stock. Let’s look at an example. An investor is interested
in a company that is trading at $100 per share. The investor decides to
buy 100 shares for $10,000. If she writes a covered
call at the same time, she’ll earn a $500 premium,
reducing the cost to $9,500, plus commissions
and contract fees. Now, suppose she was
able to write a covered call every month and
receive a similar premium amount each time. As long as the stock price
stays below the strike price of the covered
call, the premiums she earned over time,
less fees and commissions, would help make up for some
of the cost of the stock. Of course, there is no
guarantee that a covered call writer can consistently
accomplish this month after month. Short options can be assigned
at any time prior to expiration. If you’re interested in learning
about other options strategies, we’re here to help. Take a look at more of our
award-winning investing education to learn more. [MUSIC PLAYING]

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