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What is a 'Covered Call'

Covered calls are an options strategy where an investor holds a long position in an asset and writes (sells) call options on that same asset to generate an income stream. This is often employed when an investor has a short-term neutral view on the asset and for this reason holds the asset long and simultaneously has a short position via the option to generate income from the option premium. A covered call is also known as a "buy-write".

Breaking Down the 'Covered Call'

Covered calls are a neutral strategy, meaning the investor only expects a minor increase or decrease in the underlying stock price for the life of the written call option.

This strategy is not useful for a very bullish investor. A covered call serves as a short-term hedge on a long stock position and allows investors to earn income via the premium received for writing the option. However, the investor forfeits stock gains if the price moves above the option's strike price. They are also obligated to provide 100 shares (for each contract written) to the buyer of the option, at the strike price, if it is exercised.

If an investor is very bullish, they are typically better off not writing the option and just holding the stock. The option caps the profit on the stock, which could reduce the overall profit of the trade if the stock price spikes.

Similarly, if an investor is very bearish, they may be better off simply selling the stock, since the premium received for writing a call option will do little to offset the loss on the stock if the stock plummets.

Maximum Profit and Loss

The maximum profit of a covered call is equivalent to the strike price of the short call option, less the purchase price of the underlying stock, plus the premium received.

The maximum loss is equivalent to the purchase price of the underlying stock less the premium received.

Covered Call Example

An investor owns shares of hypothetical company TSJ. They like its long-term prospects as well as its share price but feel in the shorter term the stock will likely trade relatively flat, perhaps within a couple dollars of its current price of $25.

If they sell a call option on TSJ with a strike price of $27, they earn the premium from the option sale but cap their upside on the stock to $27. Assume the premium they receive for writing a three-month call option is $0.75 ($75 per contract or 100 shares).

One of three scenarios will play out:

a) TSJ shares trade below the $27 strike price. The option will expire worthless and the investor keep the premium from the option. In this case, by using the buy-write strategy they have successfully outperformed the stock. They still own the stock but have an extra $75 in their pocket, less fees.

b) TSJ shares fall and the option expires worthless. The investor keeps the premium which helps offset the decline in the stock price.

c) TSJ shares rise above $27. The option is exercised, and the upside in the stock is capped at $27. If price goes above $27.75 (strike price plus premium), the investor would have been better off holding the stock. Although, if they planned to sell at $27 anyway, writing the call option gave them an extra $0.75 per share.

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