What Is A Covered Call?

A Covered Call

A covered call is a somewhat tricky stock trading option that has been in use for the last several decades.  What a covered call offers the stock trader is a sort of insurance policy against the stocks he owns.  Additionally it will allow the investor to make money from his stocks in more ways than just waiting for the stock share price to increase.  In covered call trades the trader is offering options to other investors.  An option means there is a set price for a given stock for a future date.  There is also a premium assessed which serves as the fee to the stock options seller.  Whether the options buyer makes the future stock purchase for the price offered does not mean the premium is not paid.  In options the premium is always paid regardless if the stock options are purchased.  To better understand options, and therefore know how covered call trades function; see this example of stock options:

Seller A offers 100 shares of Stock X to the Buyer for $50 per share.  The options contract is for one year, with a premium of $5 per share.

Stock X currently trades for $45

Buyer accepts stock options contract. Guaranteed payment in the form of premium to the options seller is $500

In one year the stock is trading for $49 per share. At this amount it is cheaper for the investor to not execute the options and buy Stock X on the open market.

Options seller keeps $500 premium as profit for making the offer

The Covered Call Advantage

The advantage for covered call trades for the investor is that in a covered call, they literally own the stock or security they are offering for purchase on the option.  In this way they can safeguard their investment, the stocks they own against future loss by making money off the premium.  To continue the previous example, see how this works out well for the investor when the stock takes a loss.  In the previous example if the option was a covered call, meaning the stocks offered were owned by the seller, he (Seller A) would have:

Made $500 from the premium from his option offered

Increased his 100 shares in value from $4,500 to $4,900 while adding the premium for a net gain of $900

In this way stocks are also protected against loss.  If the stock had gone down in value from $45 to $40, the investor would have lost $500 on their stock holdings.  However if they had utilized a covered call as in the example, the premium paid to them on the options contract would have given them $500, negating their loss on the stocks.

Related posts:

1. What Is A Call?
2. What Is A Bid?
3. What Is An Ask?
4. How Do A Bid And Ask Work In Stock Trading?
5. What Are Commodities?