Covered Call

Understanding Covered Call

The Covered Call is a commonly executed trading strategy. What makes a strategy a Covered Call? Well, it involves owning or buying shares of a particular stock or security, and then selling or "writing" call options on that same underlying stock or security.

How Covered Call Works

Essentially, the mechanics of the Covered Call strategy involves two steps. First, you purchase the stock or security. Secondly, you sell call options on the stock or security you just bought. Each option contract corresponds to 100 shares of the underlying stock. By selling the call options, you earn premium income in return.

Why Use a Covered Call

There are a few key reasons why you might choose to implement a Covered Call strategy in your trading. The first is to generate income. When you sell the call option, you receive a premium from the buyer. This premium can serve as a steady source of income, particularly if the option doesn't get exercised.

The second reason to use a Covered Call is to provide a bit of downside protection. If the stock price drops, the income from the sold call option can offset some of the losses. Keep in mind, however, that this protection is limited.

Risks of a Covered Call

Like any trading strategy, the Covered Call is not without risks. The primary risk is that the stock price could surge well above the strike price. If that happens, you would be obligated to sell your shares at the strike price, missing out on any additional profit from the increased stock price.

The second risk, though less severe, is that if the stock price drops significantly, the premium received from selling the call option won't be enough to offset the losses from owning the stock. Therefore, proper understanding and management of these risks are crucial before implementing a Covered Call strategy.

Takeaway: Covered Call as a Trading Tool

The Covered Call strategy can be an effective tool in the hands of an experienced trader. It can be a steady source of income while providing some downside protection. However, like all tools, it must be used wisely and with proper risk management. Always remember to thoroughly understand any trading strategy before implementing it.