For the investor who wants to minimize the risks involved with trading stocks, a covered call is a type of options strategies that can actually be profitable and hedge your long position at the same time.
In order to use a covered call option, an investor would need to be the owner of the stock, usually a minimum of 100 shares, and have the right to buy and sell this underlying stock at a certain fixed price (known as a strike price) within a specified time frame.
Usually investors will implement this strategy when the stock has made a nice run and will likely get a pullback in the short term. So, instead of selling the stock to avoid the downturn, you can sell call options against the underlying as a type of hedge.
When you sell an option you receive a premium that you will get to keep if the option expires out of the money.
As a seller of a call option you want the price of the underlying to stay below the strike price at the time of expiration in order to keep all of the premium.
If the underlying expires one cent or more over the strike price, then your options will be assigned and you will be forced to sell the stock at the strike price.
Covered Call Example
Say you buy 100 shares of $AAPL at $100 per share and the stock runs up to $110. You still would like to hold it for the long term but you think it is going to pullback in the short term.
In order to protect yourself from a pullback, you can sell call options just out of the money at $111 for the week or for the month and collect the premium for selling them.
If the stock does pullback and the option expires worthless, you get to keep your stock and the premium. However, if the stock keeps running and closes above $111 when your options expire, then you will be assigned and your stock will be sold at the strike price.
Pros and Cons Of Covered Calls
One of the biggest pros of covered calls is that you can protect your long position and make money at the same time. However, there are some negatives from covered calls.
One of the biggest is it won’t protect you in a major sell off as the call option is only worth so much and won’t make up for how much you can lose if the stock takes a dive.
Another negative is that it only protects you for a specific amount of time as options are expiring assets.